A: Definition of Economics

Economics is growing very rapidly as the years pass. As new ideas are being discovered and the old
theories are being revised, thereIore, it is not possible to give a deIinition oI economics which has a
general acceptance.

For the sake oI convenience, the set oI deIinitions given by various economists are generally classiIied
under Iour heads:
Lconom|cs as a sc|ence of wea|th
O Economics as a science oI material welIare.
O Economics as a science oI scarcity and choice.
O Economics as a science oI growth and eIIiciency.

Economics as a Science of Wealth/Classical View:
Definition of Economics By Adam Smith:
O %here is no one deIinition oI Economics which has a general acceptance. %he Iormal roots oI the
scientiIic Iramework oI economics can be traced back to classical economists. %he pioneers oI the
science oI economics deIined economics as the science oI wealth.
O Adam Smith (1723 -1790), the Iounder oI economics, described it as a body oI knowledge which
relates to wealth. Accordingly to him iI a nation has larger amount oI wealth, it can help in
achieving its betterment. He deIined economics as:
O %he study oI nature and causes oI generating oI wealth oI a nation.
O Adam Smith in his Iamous book, 'An Enquiry into the Nature and Causes of the Wealth of
Nations` emphasized the production and expansion oI wealth as the subject matter oI economics.
O Ricardo, another British classical economist shiIted the emphasis Irom production oI wealth to
the distribution oI wealth in the study oI economics.
O 1.B. Say, a French classical economist, described economics as:%he science which treats oI
wealth.
O 1.S. Mill in the middle oI 19th century looked upon economics is as:"Practical science oI
production and distribution oI wealth.
O According to Malthus:an is motivated by selI Interest only. %he desire to collect wealth never
leaves him till he goes into the grave.
O %he main points oI the deIinitions oI economics given by the above classical economists are that:
O (i) Economics is the study oI wealth only. It deals with consumption, production, exchange and
distribution aspects oI wealth.
O (ii) Only those commodities which are scarce are Included In wealth. Non-material goods such as
air, services etc., are excluded Irom the category oI wealth.
O Criticism on the Classical Definition of Economics:
O %he deIinitions given by Adam Smith and other classical economists were severely criticized by
social reIormers and men oI letters oI that time Ruskin and Carlyle. %hey dubbed economics as a
dismal science` and a 'science oI getting rich'. %he main criticisms on these deIinitions are as
under:
O (i) Too much importance to wealth: %he deIinitions oI economics give primary importance to
wealth and secondary importance to man. %he Iact is that the study oI man is more importance
than the study oI wealth.
O (ii) Narrow meaning of wealth: %he word wealth` in the classical economist`s deIinitions oI
economics means only material goods such as chair, book, pen, etc. %hese do not include services
oI doctors, nurses, soldiers etc. In modern economics, the word wealth` includes material as well
as non-material goods.
O (iii) Concept of economic man: According to wealth deIinitions, man works only Ior his selI-
interest Social interest is ignored. Dr. arshall and his Iollowers were oI the view that economics
does not study a selIish man but a common man.
(iv) No mention of man`s welfare: %he 'Wealth' deIinitions ignore the importance oI man`s
welIare. Wealth is not be all and the end all oI all human activities.
(v) It does not study means: %he deIinitions oI economics lay emphasis on the earning oI
wealth as an end in itselI. %hey ignore the means which are scare Ior the earning oI wealth.
O (vi) Defective logic: %he deIinitions economics given by classical economists were unduly
criticized by the literacy writers oI that time. %he Iact is that what Adam Smith wrote in his book
Wealth oI Nations' (1776 still holds well. %he central argument oI the book that market
economy enables every individual to contribute his maximum to the production oI wealth oI
nation still not only holds good but is also being practiced and advocated throughout the
capitalistic world. Since the word 'wealth' did not have clear meaning, thereIore the deIinition
economics became controversial. It was regarded unscientiIic and narrow. At the end oI 19th
century, Dr. AlIred arshall gave his own deIinition oI economics and therein he laid emphasis
on man and his welIare.
Economics as a Science of Material Welfare/Neo-Classical View:
Marshall`s Definition of Economics:

%he neo-classical school led by Dr. Alfred Marshall gave economics a respectable place among social
sciences. He was the Iirst economist who liIted economics Irom the bad repute it had Iallen. Dr. AlIred
arshall (1842 - 1924) in his book, !rinciples of Economics deIined Economics as:
Study oI mankind in the ordinary business oI liIe; it examines that part oI individual and social actions
which is closely connected with the attainment and with the use oI material requisites oI well being.
%his deIinition clearly states that Economics is on the one side a study oI wealth and on the other and
more important side a part oI the study oI man. arshall`s Iollowers like !igou, Cannon and Baveridge
(the Neo-classical writers) have also deIined Economics as: Study oI causes oI material welIare.
For example, according to Cannon, the aim oI Political Economy is the explanation oI the general
cause`s en which the material welIare oI the human being depends.
Characteristics:
The definitions given by Welfare School of Economists have the following main Ieatures oI
Economics as aterial WelIare:

(i) Wealth is not the be all and the end all of human activities: Economics does not regard wealth as
the be all and the end all oI the human activities. It is only a mean to the IulIillment oI an end which is
human welIare. WelIare and not wealth is; thereIore, oI primary importance to man.

(ii) Study of an ordinary man: Economics is a study oI an ordinary man who lives in Iree society. A
person who is cut away Irom the society is not the subject oI study oI Economics.

(iii) It does not study all activities of man: Economics does not study all the activities oI man. It is
concerned with those actions which can be brought directly or indirectly with the measuring rod oI
money.

(iv) Study of material welfare: Economics is concerned with the ways in which man applies his
knowledge, skill to the giIts oI Nature Ior the satisIaction oI his material welIare.

For a long time, the deIinition oI Economics given by AlIred arshall was generally accepted. It enlarged
the scope oI economics by taking emphasis that its studies wealth and man rather than wealth alone.

However, arshall`s deIinition was criticized by ionel Robbins. He in his book Essay on the Nature
and SigniIicance oI Economic Science gave a critical review oI the welIare deIinitions oI economics.
%hese criticisms are summed as under:

Robbins's Criticism:
(i) Narrows down the scope of economics: According to Robbins, the use oI the word aterial in the
deIinition oI Economics considerably narrows down the scope oI Economics. %here are many things in
the world which are not material but they are very useIul Ior promoting human welIare. For example, the
services oI doctors, lawyers, teachers, dancers, engineers, proIessors, etc., satisIy our wants and are scarce
in supply. II we exclude these services and include only material goods, then the sphere oI economics
study will be very much restricted.
(ii) Relation between economics and welfare: %he second objection raised by Robbins on welIare
deIinition is on the establishment oI relation between Economics and WelIare. According to him, there
are many activities which do not promote human welIare, but they are regarded economic activities, e.g.,
the manuIacturing and sale oI alcohol goods or opium, etc. Here Robbins says, Why talk pI welIare at
all? Why not throw away the mask altogether?
(iii) Welfare is a vague concept: %he third objection levied by him was on the concept oI welIare`. In
his opinion welIare is a vague concept. It is purely subjective. It varies Irom man to man, Irom place to
place and Irom age to age. oreover, he says what is the use oI a concept which cannot be quantitatively
measured and on which two persons cannot agree as to what is conducive to welIare and what is not. For
example, the manuIacturing and sale oI guns, tanks and other war heads, production oI opium, liquor etc.,
are not conducive to welIare but these are all economic activities. Hence, these cannot be excluded Irom
the study oI economics.
(iv) Impractical: %he deIinition oI welIare is oI theoretical nature. It is not possible in practice to divide
man`s activities into material and non-material.
(v) It involves value judgment: Finally, the word WelIare' in the deIinition involves value judgment
and the economists according to Robbins, are Iorbidden to pass any verdict.
Economics as a Science of Scarcity and Choice:
Robbins Definition of Economics:
arshall`s deIinition oI economics remained an article oI Iaith with all economists Irom 1830 to 1932.
However, with the publication oI Robbins book Nature and Significance of Economic Science (1932),
there developed a Iresh controversy in regard to the deIinition oI economics. Lionel Robbins, aIter
criticizing the deIinitions given by the Classical and Neo-classical economists, gave his own deIinition oI
Economics. According to him:
Firstly, the deIinition oI Economics given by him is superior to that oI others because it does not contain
any reIerence oI the term material or welIare. Secondly, it applies as much to the case oI an isolated
individual as to the complicated net working oI society. Thirdly, it raises the status oI Economics to that
oI Science. Fourthly, it makes Economics a positive science which deals only with Iacts, It Iorbids the
economists to pass any value judgment oI what is good or bad, right or wrong, etc.
Lionel Robbins claiming his deIinition Economics precise, scientiIic and superior, deIines Economics
book Nature and Significance of Economics Science' (Published in 1932):
"A science which studies human behavior as a relationship between ends and scarce means which have
alternative uses".
%his deIinition is based on the Iollowing Iive pillars:
Main Pillars of Robbins's Definition:
(i) The Human wants or ends are unlimited: Human wants reIerred to as ends by Robbins are
unlimited. %hey increase in quantity and quality over a period oI time. %hey vary among individuals and
overtime Ior the same individual. It is not possible to Iind a person who will say that his wants Ior goods
and services have been completely satisIied. %his is because oI the Iact that when one want is satisIied, it
is replaced by another and there is then no end to it.
(ii) The ends or wants vary in importance: %he ends or wants are oI varying importance. %hey are
ranked in order oI importance as: (a) necessaries (b) comIorts and (c) luxuries. an generally satisIies his
urgent wants Iirst and less urgent aIterwards in order oI their importance.
(iii) Scarcity of resources: Resources are the inputs used in the production oI things which we need.
%he resources (Land, labor, capital and entrepreneurship) at the disposal oI man are scarce. %hey are not
Iound in as much quantity as we need them. Scarcity means that we do not and cannot have enough
income or wealth to satisIy our every desire. Scarcity exists because human wants always exceed what
can be produced with limited resources and time that Nature makes available to man at any one time.
Scarcity is a Iact oI liIe. It occurs among the poor and among the rich. %he richest person on earth Iaces
scarcity because he too cannot satisIy all his wants with the limited time available to him.
(iv) According to Robbins: the unlimited ends and the scarce resources provide a Ioundation to the
Iield oI Economics. Since the human wants are innumerable and the means to satisIy them are scarce or
limited in supply, thereIore, an economic problem arises. II all the things were Ireely available to satisIy
the unlimited human wants, there would not have arisen any scarcity, hence no economic goods, no need
to economic and no economic problem. Scarcity, thus, can be deIined as the excess oI human wants over
what can be actually produced in the economy.
(v) Economic resources have alternative uses: %he Iourth important proposition oI Robbins deIinition
is that the scarce resources available to satisIy human wants have alternative uses. %hey can be put to one
use at one time. For instance, iI a piece oI land is used Ior the production oI sugarcane, it cannot be
utilized Ior the growth oI another crop at the same time. an, thereIore, has to choose the best way oI
utilizing the scarce resources which have alternative uses. %he scarcity resources and choices are the key
problems conIronting every society.
%he choices to be made by it are:
O What goods shall be produced and in what quantity?
O How should the various goods and services be produced?
O How should the goods and services be distributed?
Summing up the Ioundation oI economic science according to Robbins, is based on satisIaction oI
human wants with scare resources which have alternative uses.
Merits of Robbins's Definition of Economics:
%here are many admirers oI Robbins deIinition. It has the Iollowing merits:
(i) Status of a positive science: Robbins tries to make economics a more exact science. According to
him, economics has nothing to do with ends. %hey may be noble or ignoble, material or non-material.
Economics is not concerned with them as such.
(ii) An analytical definition: Robbins deIinition makes study oI economics analytical. It studies the
particular aspect oI human behavior which is imposed by the inIluence oI scarcity.
(iii) A universal definition: Robbins deIinition is applicable everywhere. It is concerned with unlimited
wants and limited resources which is the problem Iacing every economy socialistic or capitalistic.
(iv) Clear on the nature and scope of economics: Robbins deIinition serves to speciIy the nature, scope
and subject matter oI economics. According to him, an economic problem is characterized by the
possibility oI exercising choice between ends an which have alternative uses.
(v) Valuation is the central problem: According to Robbins, valuation is the central problem oI
economics. Wherever the ends are unlimited and the resources scare, they give rise to an economic
problem arshall`s deIinition does not identity this valuation process.

Criticism on Robbins Definition of Economics or Demerits:
Robbins deIinition oI economics has been bitterly criticized by eminent writers Hicks, Longe, Durbin,
Frazer, etc., on the Iollowing grounds:
(i) Reduced economics merely to a theory of value: Robbins`s deIinition restricts the scope oI
economics by treating it as a positive Science only while in reality it is both a positive and a normative
science.

(ii) Scope of economic has been widened: Robbins`s deIinition has
widened the scope oI economics by covering the whole oI economic liIe, while it is concerned with that
part oI human liIe which is connected with the market price.
(iii) Economics has become a colorless science: Robbins`s made economics colorless, impersonal and
abstract. It is in Iact a deIinition oI economics Ior economist only.
(iv) Study of economic growth: %he study oI economic growth process remains outside the scope oI
economics while it is through economic growth that living standards improve.
Summing up: %he deIinition oI economics given by Robbins has doubt certain Ilaws. However, it is
more comprehensive in describing the problem oI resource utilization

Economics as a Science of Growth and Efficiency:
II we deIine Economics as a science oI administration oI scare resources, then its scope becomes too
wide and includes the whole oI economics liIe and not merely that part oI it which is connected with the
market price.
Latest/odern DeIinition oI Economics:
%he modern economist`s deIine economics as: "A science oI growth and eIIiciency".
According to Samuelson: "Economics is the study oI how people and society end up closing, with or
without the use oI money, to employ scarce productive resources that could have alternative uses, to
produce various commodities and distribute them Ior consumption now or in the Iuture among various
persons and groups in society".

It analyses the cost and beneIits oI improving patterns oI resource allocation.
In the words oI C.R. McConnell: Economics can be deIined as a science oI eIIiciency in the use oI
resources so as to attain the greatest or maximum IulIillment oI society`s unlimited wants. EIIiciency here
implies technical eIIiciency and economic eIIiciency in the use oI scarce resources Ior producing a given
level oI output. %he term eIIiciency also relates to the eIIiciency oI whole economics system. II one
section oI the society is made better oII without making the other section worse oII, we can say the
economic system is operating eIIiciently".
AIter considering the various deIinitions, Economics can be deIined as: ~A social science which is
concerned with the proper use and allocation of resources for the achievement and maintenance of
growth with stability and efficiency.

Scope of Economics:

%he scope of economics is the area or boundary oI the study oI economics. In scope oI economics we
answer and analyze the Iollowing three main questions:

(i) What is the subject matter oI economics?
(ii) What is the nature oI economics?
(iii) What are the limitations oI economic?

(i) Subject Matter of Economics:

%here is a diIIerence oI opinion among economists regarding the subject-matter oI economics. Adam
Smith, the Iather oI modern economic theory, deIined economics as a subject, which is mainly concerned
with the study oI nature and causes oI generation oI wealth oI nation.
Marshall introduced the concept oI welIare in the study oI economics. According to arshall;
economics is a study oI mankind in the ordinary business oI liIe. It examines that part oI individual and
social actions which is closely connected with the material requisites oI well being. In this deIinition,
arshall has shiIted the emphasis Irom wealth to man. He gives primary importance to man and
secondary importance to wealth.
%he Robbinsian`s concept oI the subject-matter oI economics is that: economics is a science which
studies human behavior as a relationship between ends and scarce means which have alternative uses.
According to Robbins (a) human wants are unlimited (b) means at his disposal to satisIy these wants are
not only limited, (c) but have alternative uses. an is always busy in adjusting his limited resources Ior
the satisIaction oI unlimited ends. %he problems that centre round such activities constitute the subject-
matters oI economics.
Paul and Samuelson, however, includes the dynamic aspects oI economics in the subject matter.
According to them, "economics is the study oI how man and society choose with or without money, to
employ productive uses to produce various commodities over time and distribute them Ior consumption
now and in Iuture among various people and groups oI society.

(ii) Nature of Economics:
%he economists are also divided regarding the nature oI economics. %he Iollowing questions are
generally covered in the nature oI economics.
(a) Is economics a science or an art?
(b) Is it a positive science or a normative science?
(iii) Economics As a Science or An Art:
Economics is both a science and an art. Economics is considered as a science because it is a systematic
knowledge derived Irom observation, study and experimentation. However, the degree oI perIection oI
economics laws is less compared with the laws oI pure sciences.
An art is the practical application oI knowledge Ior achieving deIinite ends. A science teaches us to know
a phenomenon and an art teaches us to do a thing. For example, there is inIlation in Pakistan. %his
inIormation is derived Irom positive science. %he government takes certain Iiscal and monetary measures
to bring down the general level oI prices in the country. %he study oI these Iiscal and monetary measures
to bring down inIlation makes the subject oI economics as an art.
AIter arriving at a conclusion that economics is both a science as well as an art. Here arises another
controversy. Is economics a positive science or a normative science?
(iv) Economics is Positive or Normative Science:
%here again diIIerence oI opinions among economists whether economics is a positive or normative
science. Lionel Robbins, Senior and Friedman have described economics as a positive science. %hey
opined that economics is based on logic. It is a value theory only. It is, thereIore, neutral between ends.
arshall, Pigou, Hawtrey, Keynes and many other economists regard economics as a normative science.
According to them, the real Iunction oI the science is to increase the well-being oI man. %hey have given
suggestions in their works Ior promotion oI human welIare.
For example, althus has given suggestions oI checking the rising population. . Keynes has suggested
measures to remove unemployment.
We agree with r. Frazer, that an economist who is only an economist is a poor pretty Iish. An
economist must come Iorward to give advice to the problems Iacing the human being like depression,
unemployment, high prices, etc., Ior increasing his welIare.
Economics, to conclude, has both theoretical as well as practical side. In other words, it is both a positive
and a normative science.

Methods of Economic Analysis:
An economic theory derives laws or generalizations through two methods:
(1) Deductive ethod and (2) Inductive ethod.
%hese two ways oI deriving economic generalizations are now explained in brieI:
(1) Deductive ethod oI Economic Analysis:
%he deductive method is also named as analytical, abstract or prior method. %he deductive method
consists in deriving conclusions Irom general truths, takes Iew general principles and applies them draw
conclusions.

For instance, iI we accept the general proposition that man is entirely motivated by selI-interest. In
applying the deductive method oI economic analysis, we proceed Irom general to particular.
%he classical and neo-classical school oI economists notably, Ricardo, Senior, Cairnes, J.S. ill,
althus, arshall, Pigou, applied the deductive method in their economic investigations.

Steps of Deductive Method:
%he main steps involved in deductive logic are as under:
(i) Perception of the problem to be inquired into: In the process oI deriving economic generalizations,
the analyst must have a clear and precise idea oI the problem to be inquired into.
(ii) Defining of terms: %he next step in this direction is to deIine clearly the technical terms used
analysis. Further, assumptions made Ior a theory should also be precise.
(iii) Deducing hypothesis from the assumptions: %he third step in deriving generalizations is deducing
hypothesis Irom the assumptions taken.
(iv) Testing of hypothesis: BeIore establishing laws or generalizations, hypothesis should be veriIied
through direct observations oI events in the rear world and through statistical methods. (%heir inverse
relationship between price and quantity demanded oI a good is a well established generalization).

Merits of Deductive Method:
%he main merits oI deductive method are as under:
(i) %his method is near to reality. It is less time consuming and less expensive.
(ii) %he use oI mathematical techniques in deducing theories oI economics brings exactness and clarity
in economic analysis.
(iii) %here being limited scope oI experimentation, the method helps in deriving economic theories.
(iv) %he method is simple because it is analytical.

Demerits of Deductive Method:
It is true that deductive method is simple and precise, underlying assumptions are valid.
(i) %he deductive method is simple and precise only iI the underlying assumptions are valid. ore oIten
the assumptions turn out to be based on halI truths or have no relation to reality. %he conclusions drawn
Irom such assumptions will, thereIore, be misleading.
(ii) ProIessor Learner describes the deductive method as armchair` analysis. According to him, the
premises Irom which inIerences are drawn may not
hold good at all times, and places. As such deductive reasoning is not applicable universally.

(iii) %he deductive method is highly abstract. It require; a great deal oI care to avoid bad logic or Iaulty
economic reasoning.
As the deductive method employed by the classical and neo-classical economists led to many Iacile
conclusions due to reliance on imperIect and incorrect assumptions, thereIore, under the German
Historical School oI economists, a sharp reaction began against this method. %hey advocated a more
realistic method Ior economic analysis known as inductive method.

(2) Inductive Method of Economic Analysis:
nductive method which also called empirical method was adopted by the Historical School oI
Economists". It involves the process oI reasoning Irom particular Iacts to general principle.
%his method derives economic generalizations on the basis oI (i) Experimentations (ii) Observations and
(iii) Statistical methods.
In this method, data is collected about a certain economic phenomenon. %hese are systematically
arranged and the general conclusions are drawn Irom them.
For example, we observe 200 persons in the market. We Iind that nearly 195 persons buy Irom the
cheapest shops, Out oI the 5 which remains, 4 persons buy local products even at higher rate just to
patronize their own products, while the IiIth is a Iool. From this observation, we can easily draw
conclusions that people like to buy Irom a cheaper shop unless they are guided by patriotism or they are
devoid oI commonsense.

Steps of Inductive Method:
%he main steps involved in the application oI inductive method are:
(i) Observation.
(ii) Formation oI hypothesis.
(iii) Generalization.
(iv) VeriIication.

Merits of Inductive Method:
(i) It is based on Iacts as such the method is realistic.
(ii) In order to test the economic principles, method makes statistical techniques. %he inductive method
is, thereIore, more reliable.
(iii) Inductive method is dynamic. %he changing economic phenomenon are analyzed and on the basis oI
collected data, conclusions and solutions are drawn Irom them.

(iv) Induction method also helps in Iuture investigations.

Demerits oI Inductive ethod:

%he main weaknesses oI this method are as under:
(i) II conclusions drawn Irom insuIIicient data, the generalizations obtained may be Iaulty.
(ii) %he collection oI data itselI is not an easy task. %he sources and methods employed in the collection
oI data diIIer Irom investigator to investigator. %he results, thereIore, may diIIer even with the same
problem.
(iii) %he inductive method is time-consuming and expensive.

Conclusion:
%he above analysis reveals that both the methods have weaknesses. We cannot rely exclusively on any
one oI them. odern economists are oI the view that both these methods are complimentary. %hey
partners and not rivals. Alfred Marshall has rightly remarked:

nductive and Deductive methods are both needed Ior scientiIic thought, as the right and leIt Ioot are
both needed Ior walking.
We can apply any oI them or both as the situation demands.

Economic Analysis and Economic Policy:
Economics, like other social sciences, has two aspects. One aspect is analytical and the other is practical.
Both these aspects are oI great importance because economic analysis is the basis Ior economic policy.
%hese are, in Iact, integral parts oI each other.

What is Economic Analysis or Economic Theory?
DeIinition and Explanation:
Economic analysis or economic theory is a body oI economic principles built up as a result oI logical
reasoning. We can call it a base oI tools with which the economists analyze economic problems.
Economic theory derives principles Irom Iacts which are systematically arranged and interpreted. In the
words oI Maconnell:
%he task oI economic theory is to systematically arrange, interpret and generalizes upon Iacts.

Economic theory thus is a statement or a set oI related statements about cause and eIIect, action and
reaction.

Steps Ior aking an Economic %heory:
%he main steps involved in constructing theory oI economics are as under:
(i) Selecting the problem. %he Iirst step involved in the Iormulation oI a theory is the selection oI
problem which is related to the real world.
(ii) Formulation of hypothesis. %he second step is to Iormulate hypothesis oI the economic problem to
be analyzed.
(iii) Predictions. %he third step required in the construction oI a theory is to draw implications Irom the
assumptions by way oI logical reasoning.
(iv) Testing of predictions. Finally, the predictions are tested by the process oI observation and
statistical analysis oI the data.
%he economic theory is extremely valuable in explaining economic phenomenon, predicting economic
events, judging perIormance oI the economy and in Iormulating economic policies.

What is an Economic Policy:
DeIinition and Explanation:
Economic policy is an attempt to devise government actions and to design institutions that might
improve economic perIormance.

%he creation oI speciIic policies Ior achieving economic goals oI the society is not simple and easy
matter. %he main steps in policy Iormulation are as under:

Steps for Making an Economic Policy:
(I) Clear statement of goals. %here should be clear statement oI economic goals to be achieved.
(ii) Effects of alternative policies. %he second step is to examine and consider the possible eIIects oI
alternative policies designed to achieve the economic goal. For example, while considering the merits and
demerits oI Iiscal policy in the achievement oI desired level employment, the altering monetary policy
must remain under examination.
(iii) Evaluation. %he third step is to evaluate the eIIectiveness oI the policies. %he process oI evaluation
should be continuous. II any drawback is Iound in it at any stage, it should he improved.

Goals of Economic Policies:
%here are number oI economic goals which economic policies are designed to achieve. %hese goals are:
( I ) Economic growth (ii) more jobs Ior persons willing and able to work (iii) maximum beneIits at
minimum cost Irom the limited productive resources (iv) stability in price level (v) high degree oI
Ireedom in economic activities (vi) Iair distribution oI income (vii) provision oI economic security to
disabled, handicapped, unemployed etc., (viii) reasonable Iavorable balance in balance oI payments.
%he economic goals to be achieved diIIer with the level oI employment in the country. For example, the
developed countries can aim at achieving Iull employment, proper distribution oI income and price
stability etc. %he developing countries, on the other hand, are mostly Iaced with the problems oI
unemployment, unequal distribution oI wealth, price instability etc. Each country, thereIore, must devise a
system oI priorities Ior its objectives.

II may, here also be noted that an economic theory Iormed as a basis Ior policy measure at one time is not
applicable Ior all times to come. An economic theory which is true today may be obsolete tomorrow.

Micro and Macro Analysis:
In recent years, the subject matter oI economics is divided into two broad areas. One oI them is called
Microeconomics and the other is called Macroeconomics. %hese two terms microeconomics and
macroeconomics were Iirst coined and used by Ranger Frisco in 1933. In recent years, division oI
economic theory into two separate parts has gained much importance.

Distinction/DiIIerence between icro and acro Economics:

%he distinction/difference between Micro and Macro economics is made clear below:

(1) Microeconomics:
DeIinition:
Microeconomics is a Greek word which means small.
"icroeconomics is the study oI speciIic individual units; particular Iirms, particular households,
individual prices, wages, individual industries particular commodities. %he microeconomic theory or price
theory thus is the study oI individual parts oI the economy".
It is economic theory in a microscope. For instance, in microeconomic analysis we study the demand oI
an individual consumer Ior a good and Irom there we go to derive the market demand Ior a good (that is
demand oI a group oI individuals Ior a good). Similarly, in microeconomic theory we study the behavior
oI individual Iirms the Iixation oI prices output. In the words oI Samuelson:

icroeconomics we examine among other things how individual prices are set, consider what
determines the price oI land and capital and enquire into the strength and weaknesses oI market
mechanics.

In the words oI Leftwitch: icroeconomic theory or price theory deals with the economic behavior oI
individual decision making units such as consumers, resources owners, business Iirms as well as
individuals who are too small to have an impact on the national economy".

Explanation:
(i) Microeconomics and allocation of resources. %he microeconomic theory takes the total quantity oI
resources as given. It seeks to explain how they are allocated to the production oI goods. %he allocation oI
resources to the production oI goods depends upon the price oI various goods and the prices oI Iactors oI
production. icroeconomics analyses how the relative prices oI goods and Iactors are determined. %hus
the theory oI product pricing and the theory oI Iactor pricing (rent wages, interest and proIit) Iall within
the domain oI micro economics.

(ii) Micro economics and economic efficiency. %he microeconomic theory seeks to explain whether the
problems oI scarcity and allocation oI resources so determined are eIIicient. Economic eIIiciency involves
(a) eIIiciency in consumption (b) eIIiciency in production and distribution and (c) over all economic
eIIiciency. %he price theory shows under hat conditions these eIIiciencies are achieved.

Importance:
BeIore Keynesian revolution, the body oI economics mainly consisted oI micro economics. %he classical
economics as well as the neo-classical
economics belonged to the domain oI micro economics.

%he importance and uses oI micro economics in brieI are as under.

(i) Helpful in understanding the working of private enterprise economy. %he micro economics helps
us to understand the working oI Iree market economy. It tells us as to how the prices oI the products and
the Iactors oI production are determined.
(ii) Helps in knowing the conditions of efficiency. icro economics help in explaining the conditions
oI eIIiciency in consumption, production and in distribution oI the rewards oI Iactors oI production.
(iii) Working economy without central control. %he micro economics reveals how a Iree enterprise
economy Iunctions without any central control.
(iv) Study of welfare economy. icro economic involves the study oI welIare economics.

Limitations:
icroeconomics despite its many advantages is not Iree Irom limitations. %hey in brieI are:
i) Assumption oI Iull employment in the economy which is unrealistic.
ii) Assumption oI liaises Iair policy which is no longer in practice in any country oI the world.
iii) It studies part oI the economy and not the whole.

Summing up, microeconomics is the study oI the decisions people and businesses and the interaction oI
those decisions in the market. It analyses the trees` oI the economy as distinct Irom the Iorest`.

(2) Macroeconomics:
DeIinition:
%he term macro is derived Irom the Greek word uakpo` which means large. acroeconomics, the other
halI oI economics, is the study oI the behavior oI the economy as a whole. In other words:
"Macroeconomics deals with total or big aggregates such as national income, output and employment,
total consumption, aggregate saving and aggregate investment and the general level oI prices". In the
words oI Boulding:

acroeconomics deals not with individual quantities as such but with aggregates oI these quantities, not
with individual i.e., but with the national Income, not with individual prices but with the price level, not
with Individual outputs but with the national output. It studies determination oI national output and its
growth overtime. It also studies the problems oI recession, unemployment inIlation, the balance oI
international payments and the policies adopted by the governments to deal with these problems".

Explanation:

%he main issues which are addressed in macro economics are in brieI as under:
(i) It helps understanding determination of income and employment. Late J.. Keynes laid great
stress on macro-economic analysis. In his revolutionary book, General %heory, Employment interest and
oney" brought drastic changes in economic thinking. He explained the Iorces or Iactors which
determine the level oI aggregate employment and output in the economy.
(ii) Determination of general level of prices. acro economic analysis answers questions as to how the
general price level is determined and what is the importance oI various Iactors which inIluence general
price level.
(iii) Economic growth. %he macro-economic models help us to Iormulate economic policies Ior
achieving long run economic growth with stability. %he new developed growth theories explain the
causes oI poverty in under developed countries and suggest remedies to overcome them.
(iv) Macro economics and business cycles. It is in terms oI macroeconomics that causes oI Iluctuations
in the national income are analyzed. It has also been possible now to Iormulate policies Ior controlling
business cycles i.e. inIlation and deIlation.
(v) International trade. Another important subject oI macro-economics is to analyze the various
aspects oI international trade in goods, services and balance oI payment problems, the eIIect oI exchange
rate on balance oI payment etc.
(vi) Income shares from the national income. r. . Kalecki and Nicholas Kelder, by making
departure Irom Ricarde theory, have presented a macro theory oI distribution oI income. According to
these economists, the relative shares oI wages and proIits depend upon the ratio oI investment to national
income.
(vii) Unemployment. Another macro economic issue is to explain the causes oI unemployment in the
economy. StagIlation is another important issue oI modern, economics. %he Keynesian and post
Keynesian economists are putting lot oI eIIorts in explaining the causes oI cyclical unemployment and
high unemployment coupled with inIlation and suggesting remedies to counteract them.
(viii) Macro Economic Policies. Fiscal and monetary policies aIIect the perIormance oI the economy.
%hese two major types` policies are central in macro economic analysis oI the economy.
(ix) Global Economic System. In macro economic analysis, it is emphasized that a nation`s economy is a
part oI a global economic system. A good or weak perIormance oI a nation`s economy can aIIect the
perIormance oI the world economy as a whole.

Limitations:

%he main limitations oI macro economics are as Iollows:
(i) %he macro economies ignore the welIare oI the individual. For instance, iI national saving is increased
at the cost oI individual welIare, it is not considered a wise policy.
(ii) %he macro economics analysis regards aggregates as homogeneous but does not look into its internal
composition. For instance, iI the wages oI the clerks Iall and the wages oI the teachers rise, the average
wage may remain the same.

(iii) It is not necessary that all aggregate variables are important. For instance, national income is the total
oI individual incomes. II national income in the country goes up, it is not necessary that the income oI all
the individuals in the country will also rise. %here is a possibility that the rise in national income may be
due to the increase in the incomes oI a Iew rich Iamilies oI the country.


Interdependence of Micro and Macro Economics:

%he classical approach to macro economics is that individuals and Iirms act in their own best interest. %he
wages and prices adjust quickly to achieve equilibrium in the Iree market economy.
%he Keynesian approach to macro economics is that wages and prices do not adjust rapidly and
unemployment may remain high Ior a long time. %he Keynesians are oI the view that government
intervention in the economy can help in improving economic perIormance.
Conclusion:

%he micro and macro economics are interdependent. %hey are complementary and not conIlicting. We
cannot put them in water tight compartments. Both these approaches help us in analyzing the working oI
the economy. II we study one approach and neglect the other, we are considered to be only halI educated.

We should integrate the two approaches Ior the successIul analysis oI the working oI economic system.
%he macro approach should be applied where aggregate entities are involved and micro approach when
individual cases are to be examined. II we ignore one and lay emphasis on the other, it will lead to wrong
or inadequate conclusions.
Importance of the Study of Economics:
%he importance and utility of the subject of Economics can be judged Irom this Iact that it is now
considered to be one oI the most important and useIul subject as compared to any other branch oI
knowledge. %he reasons Ior gaining its importance are that it makes human welIare its direct and primary
concern.

It helps in raising the quality oI economic liIe. As it greatly helps in the solution oI economic and. social
problems so it exercises an over-whelming inIluence on the minds oI the people. In the words oI Durbin:

Economics is the intellectual religion oI the day.

About the importance oI Economics Malthus remarks:
Political economy is perhaps the only science oI which it may be said that the ignorance oI it is not
merely a deviation oI good but produces great positive evil.

Edmund Burks is not wrong in saying that:

%he age oI chivalry has gone, that oI sophistry, economists, and calculators has succeeded.

Advantages of the Study of Economics:
%he advantages oI the study oI economics are as under:
(1) Intellectual Value: %he knowledge oI Economics is very useIul as it broadens our outlook, sharpens
our intellect, and inculcates in us the habit oI balanced thinking. %he study oI Economics makes us realize
that we as human beings are dependent upon one another Ior our daily needs. %his Ieeling creates in us
the intelligent appreciation oI our position and the spirit oI co-operation with others.
(2) Practical Advantages: %he practical advantages oI Economics are much more important than its
theoretical advantages. %hese advantages can be looked at Irom the individual and community point oI
view.

(3) Personal Stake in Economics: From personal point oI view, the study oI Economics is useIul as it
enables each oI us to understand better and appreciate more intelligently the nature and signiIicance oI
our money earning and money spending activities. With the knowledge oI Economics, the consumer can
better adjust his expenditure to his income. %he study oI Economics is also useIul to a producer. It
suggests him the ways oI bringing about the most economical combinations oI the various Iactors oI
production at his disposal. It also helps in solving the various intricacies oI exchange. From the study oI
Economics, one can easily judge as to why the prices have risen or Iallen. %he knowledge oI Economics
also explains us as to how the reward oI various Iactors oI production is determined. %hus, we Iind that
every` individual can rightly hope to become a better and more eIIicient consumer, producer and
businessman, iI he has the working knowledge oI economics.

(4) Economics for the Leader: %he study oI economics is not only helpIul Irom the individual point oI
view but it is also very useIul Ior the welIare oI the community. It enables a statesman to understand and
better grasp the economic and social problems Iacing the country. Every government has to tackle
diIIerent kinds oI economic problems such as unemployment, inIlation, over production, under-
production, imposition oI tariIIs and control, problem oI monopolies, etc. the statesman can successIully
solve these problems, iI he has thorough knowledge oI the subject oI Economics. %he knowledge oI
Economics Ior a Iinance minister is also indispensable. He has to raise revenue by imposing taxes on the
incomes oI the people Ior meeting the necessary expenditure oI the government. Economics here comes
to his rescue and guides him as to how the taxes could be levied and collected.

(5) Poverty and Development: %he greatest advantage oI Economics is that it helps in removing traces
oI poverty Irom the country. %ake the case oI Pakistan; we in Pakistan are conIronted with diIIerent kinds
oI problems. For example, low-per capita income, low productivity oI agriculture, slow development oI
industries, Iast increase in population, under-developed means oI communication and transport, etc. %he
study oI Economics helps in devising ways and means and suggesting practical measures in solving these
problems.

(6) Economics for the citizen: Such being, the importance oI study oI Economics, it is rightly remarked
by Wooten that you cannot be in real sense a citizen unless you are also in some degree an economist.
He is perIectly right in giving the statement. %he world is so Iast changing that we are completely now
living in a world dominated by economic Iorces and economic ideas. II the people oI any country do not
have the working knowledge oI an economic system; then the government oI that country can easily
hoodwink citizens have knowledge oI Economics, then the government will be very vigilant and spend
the money in a wise manner.

%he importance oI the study oI Economies can also be judged Irom this Iact that the daily newspapers
cannot be understood without some knowledge oI Economics. %he newspapers oIten describe
complicated economic problems such as inIlation, balance oI payment, balance oI trade, imperIect
markets, dumping, co-operative Iarming, sub-division and Iragmentation oI holdings, mechanization oI
agriculture, II you do not have working knowledge oI Economics, you cannot understand these diverse
problems.

From brieI discussion, we conclude, that the knowledge oI Economics is very useIul. As such it is
necessary that every citizen, worker, administrator, consumer, etc., should have at least working
knowledge oI it. In the words oI Sir Henry Clay:

Some study oI Economics is at one a practical necessity and a normal obligation.
B: Nature of Managerial Economics
%he prime Iunction oI a management executive in a business organization is decision making and Iorward
planning. Decision aking means the process oI selecting one action Irom two or more alternative
courses oI action whereas Iorward planning means establishing plans Ior the Iuture. %he question oI
choice arises because resources such as capital, land, labour and management are limited and can be
employed in alternative uses. %he decision making Iunction thus becomes one oI making choices or
decisions that will provide the most eIIicient means oI attaining a desired end, say, proIit maximization.
Once decision is made about the particular goal to be achieved, plans as to production, pricing, capital,
raw materials, labour, etc., are prepared. Forward planning thus goes hand in hand with decision making.
A signiIicant characteristic oI the conditions, in which business organizations work and take decisions, is
uncertainty. And this Iact oI uncertainty not only makes the Iunction oI decision making and Iorward
planning complicated but adds a diIIerent dimension to it. II knowledge oI the Iuture were perIect, plans
could be Iormulated without error and hence without any need Ior subsequent revision. In the real world,
however, the business manager rarely has complete inIormation and the estimates about Iuture predicted
as best as possible. As plans are implemented over time, more Iacts become known so that in their light,
plans may have to be revised, and a diIIerent course oI action adopted. anagers are thus engaged in a
continuous process oI decision making through an uncertain Iuture and the overall problem conIronting
them is one oI adjusting to uncertainty.
In IulIilling the Iunction oI decision making in an uncertainty Iramework, economic theory can be pressed
into service with considerable advantage. Economic theory deals with a number oI concepts and
principles relating, Ior example, to proIit, demand, cost, pricing production, competition, business cycles,
national income, etc., which aided by allied disciplines like Accounting. Statistics and athematics can
be used to solve or at least throw some light upon the problems oI business management. %he way
economic analysis can be used towards solving business problems. Constitutes the subject matter oI
anagerial Economics.
Definition of Managerial Economics
According to cNair and eriam, "anagerial Economics consists oI the use oI economic modes oI
thought to analyse business situation."
Spencer and Siegelman have deIined anagerial Economics as "%he integration oI economic theory with
business practice Ior the purpose oI Iacilitating decision making and Iorward planning by management."
We may, thereIore deIine anagerial Economics as the discipline which deals with the application oI
economic theory to business management. anagerial Economics thus lies on the borderline between
economics and business management and serves as a bridge between economics and business
management.
Chart 1 - Economics, Business Management and Managerial Economics.

Application of Economics to Business Management
%he application oI economics to business management or the integration oI economic theory with
business practice, as Spencer and Siegelman have put it, has the Iollowing aspects :-
1. Reconciling traditional theoretical concepts oI economics in relation to the actual business behavior
and conditions. In economic theory, the technique oI analysis is one oI model building whereby certain
assumptions are made and on that basis, conclusions as to the behavior oI the Iirms are drown. %he
assumptions, however, make the theory oI the Iirm unrealistic since it Iails to provide a satisIactory
explanation oI that what the Iirms actually do. Hence the need to reconcile the theoretical principles
based on simpliIied assumptions with actual business practice and develops appropriate extensions and
reIormulation oI economic theory, iI necessary.
2. Estimating economic relationships, viz., measurement oI various types oI elasticities oI demand such as
price elasticity, income elasticity, cross-elasticity, promotional elasticity, cost-output relationships, etc.
%he estimates oI these economic relationships are to be used Ior purposes oI Iorecasting.
3. Predicting relevant economic quantities, eg., proIit, demand, production, costs, pricing, capital, etc., in
numerical terms together with their probabilities. As the business manager has to work in an
environment oI uncertainty, Iuture is to be predicted so that in the light oI the predicted estimates,
decision making and Iorward planning may be possible.
4. Using economic quantities in decision making and Iorward planning, that is, Iormulating business
policies and, on that basis, establishing business plans Ior the Iuture pertaining to proIit, prices, costs,
capital, etc. %he nature oI economic Iorecasting is such that it indicates the degree oI probability oI
various possible outcomes, i.e. losses or gains as a result oI Iollowing each one oI the strategies
available. Hence, beIore a business manager there exists a quantiIied picture indicating the number o
courses open, their possible outcomes and the quantiIied probability oI each outcome. Keeping this
picture in view, he decides about the strategy to be chosen.
5. Understanding signiIicant external Iorces constituting the environment in which the business is
operating and to which it must adjust, e.g., business cycles, Iluctuations in national income and
government policies pertaining to public Iinance, Iiscal policy and taxation, international economics
and Ioreign trade, monetary economics, labour relations, anti-monopoly measures, industrial licensing,
price controls, etc. %he business manager has to appraise the relevance and impact oI these external
Iorces in relation to the particular business unit and its business policies.
Characteristics of Managerial Economics
It would be useIul to point out certain chieI characteristics oI anagerial Economics, in as much it`s they
throw Iurther light on the nature oI the subject matter and help in a clearer understanding thereoI.
1. anagerial Economics is micro-economic in character.
2. anagerial Economics largely uses that body oI economic concepts and principles, which is known as
'%heory oI the Iirm' or 'Economics oI the Iirm'. In addition, it also seeks to apply ProIit %heory, which
Iorms part oI Distribution %heories in Economics.
3. anagerial Economics is pragmatic. It avoids diIIicult abstract issues oI economic theory but involves
complications ignored in economic theory to Iace the overall situation in which decisions are made.
Economic theory appropriately ignores the variety oI backgrounds and training Iound in individual
Iirms but anagerial Economics considers the particular environment oI decision making.
4. anagerial Economics belongs to normative economics rather than positive economics (also
sometimes known as Descriptive Economics). In other words, it is prescriptive rather than descriptive.
%he main body oI economic theory conIines itselI to descriptive hypothesis, attempting to generalize
about the relations among diIIerent variables without judgment about what is desirable or undesirable.
For instance, the law oI demand states that as price increases. Demand goes down or vice-versa but this
statement does not tell whether the outcome is good or bad. anagerial Economics, however, is
concerned with what decisions ought to be made and hence involves value judgments.
Production and Supply
Production analysis is narrower in scope than cost analysis. Production analysis Irequently proceeds in
physical terms while cost analysis proceeds in monetary terms. Production analysis mainly deals with
diIIerent production Iunctions and their managerial uses.
Supply analysis deals with various aspects oI supply oI a commodity. Certain important aspects oI supply
analysis are supply schedule, curves and Iunction, law oI supply and its limitations. Elasticity oI supply
and Factors inIluencing supply.
Pricing Decisions, Policies and Practices
Pricing is a very important area oI anagerial Economics. In Iact, price is the ness oI the revenue oI a
Iirm and as such the success oI a business Iirm largely depends on the correctness oI the prices decisions
taken by it. %he important aspects dealt with under this area are :- Price Determination in various arket
Forms, Pricing methods, DiIIerential Pricing, Product-line Pricing and Price Forecasting.
Profit Management
Business Iirms are generally organized Ior the purpose oI making proIits and, in long run, proIits provide
the chieI measure oI success. In this connection, an important point worth considering is the element oI
uncertainty exiting about proIits because oI variations in costs and revenues which, in turn, are caused by
torso both internal and external to the Iirm. II knowledge about the Iuture were Iact, proIit analysis would
have been a very easy task. However, in a world oI certainty, expectations are not always realized so that
proIit planning and measurement constitute the diIIicult are oI anagerial Economics. %he important acts
covered under this area are :- Nature and easurement oI ProIit, ProIit %esting and %echniques oI ProIit
Planning like Break-Even Analysis.
Capital Management
OI the various types and classes oI business problems, the most complex and able some Ior the business
manager are likely to be those relating to the Iirm`s investments. Relatively large sums are involved, and
the problems are so complex that their disposal not only requires considerable time and labour but is a
term Ior top-level decision. BrieIly, capital management implies planning and trolls oI capital
expenditure. %he main topics dealt with are :- Cost oI Capital, Rate return and Selection oI Project.

%he various aspects outlined above represent the major uncertainties which a business Iirm has to reckon
with, viz., demand uncertainty, cost uncertainty, price certainty, proIit uncertainty, and capital
uncertainty. We can, thereIore, conclude the subject matter oI anagerial Economic consists oI applying
economic cripples and concepts towards adjusting with various uncertainties Iaced by a business Iirm.
Managerial Economics and Other Subjects
Yet another useIul method oI throwing light upon the nature and scope oI anagerial Economics is to
examine its relationship with other subjects. In this connection, Economics, Statistics, athematics and
Accounting deserve special mention.
Managerial Economics and Economics
anagerial Economics has been described as economics applied to decision making. It may be viewed as
a special branch oI economics bridging the gulI between pure economic theory and managerial practice.
Economics has two main divisions :- (i) icroeconomics and (ii) acroeconomics. icroeconomics has
been deIined as that branch oI economics where the unit oI study is an individual or a Iirm.
acroeconomics, on the other hand, is aggregate in character and has the entire economy as a unit oI
study.icro economics is that branch oI economic analysis which studies the behaviour oI a particular
unit may be a particular Iirm, individual.
Macroeconomics
icroeconomics, also known as price theory (or arshallian economics) is the main source oI concepts
and analytical tools Ior managerial economics. %o illustrate various micro-economic concepts such as
elasticity oI demand, marginal cost, the short and the long runs, various market Iorms, etc., all are oI great
signiIicance to managerial economics. %he chieI contribution oI macroeconomics is in the area oI
Iorecasting. %he modern theory oI income and employment has direct implications Ior Iorecasting general
business conditions. As the prospects oI an individual Iirm oIten depend greatly on general business
conditions, individual Iirm Iorecasts depend on general business Iorecasts.
Where as acroeconomics is that branch oI economic analysis which studies the behaviour oI the units in
aggregate, like national out put, employment or the entire market.

Managerial Economics and Management Accounting
anagerial Economics is also closely related to accounting, which is concerned with recording the
Iinancial operations oI a business Iirm. Indeed, accounting inIormation is one oI the principal sources oI
data required by a managerial economist Ior his decision making purpose. For instance, the proIit and loss
statement oI a Iirm tells how well the Iirm has done and the inIormation it contains can be used by
managerial economist to throw signiIicant light on the Iuture course oI action - whether it should improve
or close down. OI course, accounting data call Ior careIul interpretation. Recasting and adjustment beIore
they can be used saIely and eIIectively.
It is in this context that the growing link between management accounting and managerial economics
deserves special mention. %he main task oI management accounting is now seen as being to provide the
sort oI data which managers need iI they are to apply the ideas oI managerial economics to solve business
problems correctly; the accounting data are also to be provided in a Iorm so as to Iit easily into the
concepts and analysis oI managerial economics.
Uses of Managerial Economics
anagerial economics accomplishes several objectives.
First, it presents those aspects oI traditional economics, which are relevant Ior business decision making it
real liIe. For the purpose, it calls Irom economic theory the concepts, principles and techniques oI
analysis which have a bearing on the decision making process. %hese are, iI necessary, adapted or
modiIied with a view to enable the manager take better decisions. %hus, managerial economics
accomplishes the objective oI building suitable tool kit Irom traditional economics.
Secondly, it also incorporates useIul ideas Irom other disciplines such a psychology, sociology, etc., iI
they are Iound relevant Ior decision making. In Iact managerial economics takes the aid oI other academic
disciplines having a bearing upon the business decisions oI a manager in view oI the carious explicit and
implicit constraints subject to which resource allocation is to be optimized.
%hirdly, managerial economics helps in reaching a variety oI business decisions.
1. What products and services should be produced?
2. What inputs and production techniques should be used?
3. How much output should be produced and at what prices it should be sold?
4. What are the best sizes and locations oI new plants?
5. How should the available capital be allocated?
Role and Responsibilities of Managerial Economist
A managerial economist can play a very important role by assisting the anagement in using the
increasingly specialized skills and sophisticated techniques which are required to solve the diIIicult
problems oI successIul decision making and Iorward planning. %hat is why, in business concerns, his
importance is being growingly recognized. In developed countries like the U.S.A., large companies
employ one or more economists. In our country (India) too, big industrial houses have come to recognize
the need Ior managerial economists, and there are Irequent advertisements Ior such positions. %atas and
Hindustan Lever employ economists. Indian Petrochemicals Corporation Ltd., a Government oI India
undertaking, also keeps an economist.
Let us examine in speciIic terms how a managerial economist can contribute to decision making in
business.
In this connection, two important questions need be considered :-
1. What role does he play in business, that is, what particular management problems lend themselves to
solution through economic analysis?
2. How can the managerial economist best serve management, that is, what are the responsibilities oI a
successIul managerial economist?
Role of Managerial Economist
One oI the principal objectives oI any management in its decision making process is to determine the key
Iactors which will inIluence the business over the period ahead. In general, these Iactors can be divided
into two category, viz., (i) External and (ii) Internal. %he external Iactors lie outside the control
management because they are external to the Iirm and are said to constitute business environment. %he
internal Iactors lie within the scope and operations oI a Iirm and hence within the control oI management,
and they are known as business operations.
%o illustrate, a business Iirm is Iree to take decisions about what to invest, where to invest, how much
labour to employ and what to pay Ior it, how to price its products and so on but all these decisions are
taken within the Iramework oI a particular business environment and the Iirm`s degree oI Ireedom
depends on such Iactors as the government`s economic policy, the actions oI its competitors and the like.
Specific Functions
A Iurther idea oI the role oI managerial economists can be seen Irom the Iollowing speciIic Iunctions
perIormed by them as revealed by a survey pertaining to Britain conducted by K.J.W. Alexander and
Alexander G. Kemp :-
1. Sales Iorecasting.
2. Industrial market research.
3. Economic analysis oI competing companies.
4. Pricing problems oI industry.
5. Capital projects.
6. Production programs.
7. Security/investment analysis and Iorecasts.
8. Advice on trade and public relations.
9. Advice on primary commodities.
10. Advice on Ioreign exchange.
11. Economic analysis oI agriculture.
12. Analysis oI underdeveloped economics.
13. Environmental Iorecasting.
%he managerial economist has to gather economic data, analyze all pertinent inIormation about the
business environment and prepare position papers on issues Iacing the Iirm and the industry. In the case
oI industries prone to rapid technological advances, he may have to make a continuous assessment oI the
impact oI changing technology. He may have to evaluate the capital budget in the light oI short and long-
range Iinancial, proIit and market potentialities. Very oIten, he may have to prepare speeches Ior the
corporate executives.
It is thus clear that in practice managerial economists perIorm many and varied Iunctions. However, oI
these, marketing Iunctions, i.e., sales Iorecasting and industrial market research, has been the most
important. For this purpose, they may compile statistical records oI the sales perIormance oI their own
business and those relating to their rivals, carry our analysis oI these records and report on trends in
demand, their market shares, and the relative eIIiciency oI their retail outlets. %hus while carrying out
their Iunctions; they may have to undertake detailed statistical analysis. %here are, oI course, diIIerences
in the relative importance oI the various Iunctions perIormed Irom Iirm to Iirm and in the degree oI
sophistication oI the methods used in carrying them out. But there is no doubt that the job oI a managerial
economist requires alertness and the ability to work under pressure.
Indian Context
In the Indian context, a managerial economist is expected to perIorm the Iollowing Iunctions :-
1. acro-Iorecasting Ior demand and supply.
2. Production planning at macro and micro levels.
3. Capacity planning and product-mix determination.
4. Economics oI various productions lines.
5. Economic Ieasibility oI new production lines/processes and projects.
6. Assistance in preparation oI overall development plans.
7. Preparation oI periodical economic reports bearing on various matters such as the company`s product-
lines, Iuture growth opportunities, market pricing situation, general business, and various
national/international Iactors aIIecting industry and business.
8. Preparing brieIs, speeches, articles and papers Ior top management Ior various Chambers, Committees,
Seminars, ConIerences, etc.
9. Keeping management inIormed o various national and international developments on
economic/industrial matters.
With the adoption oI the New Economic Policy, in 1991, the macro-economic Environment in India is
changing Iast at a pace that has been rarely witnessed beIore. And these changes have tremendous
implications Ior business. %he managerial economist has to play a much more signiIicant role. He has to
constantly gauge the possibilities oI translating the rapidly changing economic scenario into viable
business opportunities. As India marches towards globalization, he will have to interpret the global
economic events and Iind out how his Iirm can avail itselI oI the carious export opportunities or oI
establishing plants abroad either wholly owned or in association with local partners.
Responsibilities of Managerial Economist
Having examined the signiIicant opportunities beIore a managerial economist to contribute to managerial
decision making, let us now examine how he can best serve the management. For this, he must
thoroughly recognize his responsibilities and obligations.
A managerial economist can serve management best only iI he always keeps in mind the main objective
oI his business, viz., to make a proIit on its invested capital. His academic training and the critical
comments Irom people outside the business may lead a managerial economist to adopt an apologetic or
deIensive attitude towards proIits. Once management notices this, his eIIectiveness is almost sure to be
lost. In Iact, he cannot expect to succeed in serving management unless he has a strong personal
conviction that proIits are essential and that his chieI obligation is to help enhance the ability oI the Iirm
to make proIits.
ost management decisions necessarily concern the Iuture, which is rather uncertain. It is, thereIore,
absolutely essential that a managerial economist recognizes his responsibility to make successIul
Iorecasts. By making best possible Iorecasts and through constant eIIorts to improve upon them, he
should aim at minimizing, iI not completely eliminating, the risks involved in uncertainties, so that the
management can Iollow a more orderly course oI business planning. At times, he will have to reassure the
management that an important trend will continue; in other cases, he may have to point out the
probabilities oI a turning point in some activity oI importance to management. In any case, he must be
willing to make considered but Iairly positive statements about impending economic developments, based
upon the best possible inIormation and analysis and stake his reputation upon his judgment. Nothing will
build management conIidence in a managerial economist more quickly and thoroughly than a record oI
successIul Iorecasts, well-documented in advance and modestly evaluated when the actual results become
available.
A Iew corollaries to the above proposition need also be emphasized here.
First, he has a major responsibility to "alert management at the earliest possible moment" in case he
discovers an error in his Iorecast. By promptly drawing attention to changes in Iorecasting conditions, he
will not only assist management in making appropriate adjustment in policies and programs but will also
be able to strengthen his own position as a member oI the management team by keeping his Iingers on the
economic pulse oI the business.
Secondly, he must establish and maintain many contacts with individuals and data sources, which would
not be immediately available to the other members oI the management. Extensive Iamiliarity with
reIerence sources and material is essential, but it is still more important that he knows individuals who are
specialists in particular Iields having a bearing on his work. For this purpose, he should join proIessional
associations and take active part in them. In Iact, one oI the best means oI determining the caliber oI a
managerial economist is to evaluate his ability to obtain inIormation quickly by personal contacts rather
than by lengthy research Irom either readily available or obscure reIerence sources. Within any business,
there may be a wealth oI knowledge and experience but the managerial economist would be really useIul
iI he can supplement the existing know-how with additional inIormation and in the quickest possible
manner.
Again, iI a managerial economist is to be really helpIul to the management in successIul decision making
and Iorward planning, he must be able to earn Iull status on the business team. He should be ready and
even oIIer himselI to take up special assignments, be that in study teams, committees or special projects.
For, a managerial economist can only Iunction eIIectively in an atmosphere where his success or Iailure
can be traced not only to his basic ability, training and experience, but also to his personality and capacity
to win continuing support Ior himselI and his proIessional ideas. OI course, he should be able to express
himselI clearly and simply and must always try to minimize the use oI technical terminology in
communicating with his management executives. For, it is well-known that iI management does not
understand, it will almost automatically reject. Further, while intellectually he must be in tune with
industry`s thinking the wider national perspective should not be absents Irom his advice to top
management.
"uestions on Managerial Economics
1. DeIine managerial economics with deIinition.
2. How does managerial economics diIIer Irom economics?
3. Write a short note on managerial economist.
4. Explain the scope oI managerial economics.
5. Explain role and responsibilities oI managerial economist
Decision Making
Decision-making is an essential aspect oI modern management. It is a primary Iunction oI management.
A manager's major job is sound/rational decision-making. He takes hundreds oI decisions consciously and
subconsciously. Decision-making is the key part oI manager's activities. Decisions are important as they
determine both managerial and organizational actions. A decision may be deIined as "a course oI action
which is consciously chosen Irom among a set oI alternatives to achieve a desired result." It represents a
well-balanced judgment and a commitment to action.
It is rightly said that the Iirst important Iunction oI management is to take decisions on problems and
situations. Decision-making pervades all managerial actions. It is a continuous process. Decision-making
is an indispensable component oI the management process itselI.
eans and ends are linked together through decision-making. %o decide means to come to some deIinite
conclusion Ior Iollow-up action. Decision is a choice Irom among a set oI alternatives. %he word
'decision' is derived Irom the Latin words de ciso which means 'a cutting away or a cutting oII or in a
practical sense' to come to a conclusion. Decisions are made to achieve goals through suitable Iollow-up
actions. Decision-making is a process by which a decision (course oI action) is taken. Decision-making
lies embedded in the process oI management.
According to Peter Drucker, "Whatever a manager does, he does through decision-making". A manager
has to take a decision beIore acting or beIore preparing a plan Ior execution. oreover, his ability is very
oIten judged by the quality oI decisions he takes. %hus, management is always a decision-making process.
It is a part oI every managerial Iunction. %his is because action is not possible unless a Iirm decision is
taken about a business problem or situation.
%his clearly suggests that decision-making is necessary in planning, organising, directing, controlling and
staIIing. For example, in planning alternative plans are prepared to meet diIIerent possible situations. Out
oI such alternative plans, the best one (i.e., plan which most appropriate under the available business
environment) is to be selected. Here, the planner has to take correct decision. %his suggests that decision-
making is the core oI planning Iunction. In the same way, decisions are required to be taken while
perIorming other Iunctions oI management such as organising, directing, staIIing, etc. %his suggests the
importance oI decision-making in the whole process oI management.
%he eIIectiveness oI management depends on the quality oI decision-making. In this sense, management
is rightly described as decision-making process. According to R. C. Davis, "management is a decision-
making process." Decision-making is an intellectual process which involves selection oI one course oI
action out oI many alternatives. Decision-making will be Iollowed by second Iunction oI management
called planning. %he other elements which Iollow planning are many such as organising, directing,
coordinating, controlling and motivating.
Decision-making has priority over planning Iunction. According to Peter Drucker, it is the top
management which is responsible Ior all strategic decisions such as the objectives oI the business, capital
expenditure decisions as well as such operating decisions as training oI manpower and so on. Without
such decisions, no action can take place and naturally the resources would remain idle and unproductive.
%he managerial decisions should be correct to the maximum extent possible. For this, scientiIic decision-
making is essential.
2. Definitions of Decision-making
1. %he OxIord Dictionary deIines the term decision-making as "the action oI carrying out or carrying into
eIIect".
2. According to %rewatha & Newport, "Decision-making involves the selection oI a course oI action Irom
among two or more possible alternatives in order to arrive at a solution Ior a given problem".
3. Characteristics of Decision Making
1. Decision making implies choice: Decision making is choosing Irom among two or more alternative
courses oI action. %hus, it is the process oI selection oI one solution out oI many available. For any
business problem, alternative solutions are available. anagers have to consider these alternatives and
select the best one Ior actual execution. Here, planners/ decision-makers have to consider the business
environment available and select the promising alternative plan to deal with the business problem
eIIectively. It is rightly said that "Decision-making is Iundamentally choosing between the
alternatives". In decision-making, various alternatives are to be considered critically and the best one is
to be selected. Here, the available business environment also needs careIul consideration. %he
alternative selected may be correct or may not be correct. %his will be decided in the Iuture, as per the
results available Irom the decision already taken. In short, decision-making is Iundamentally a process
oI choosing between the alternatives (two or more) available. oreover, in the decision-making
process, inIormation is collected; alternative solutions are decided and considered critically in order to
Iind out the best solution among the available. Every problem can be solved by diIIerent methods.
%hese are the alternatives and a decision-maker has to select one alternative which he considers as most
appropriate. %his clearly suggests that decision-making is basically/Iundamentally choosing between
the alternatives. %he alternatives may be two or more. Out oI such alternatives, the most suitable is to
be selected Ior actual use. %he manager needs capacity to select the best alternative. %he beneIits oI
correct decision-making will be available only when the best alternative is selected Ior actual use.
2. Continuous activity/process: Decision-making is a continuous and dynamic process. It pervades all
organizational activity. anagers have to take decisions on various policy and administrative matters.
It is a never ending activity in business management.
3. ental/intellectual activity: Decision-making is a mental as well as intellectual activity/process and
requires knowledge, skills, experience and maturity on the part oI decision-maker. It is essentially a
human activity.
4. Based on reliable inIormation/Ieedback: Good decisions are always based on reliable inIormation. %he
quality oI decision-making at all levels oI the Organisation can be improved with the support oI an
eIIective and eIIicient management inIormation system (IS).
5. Goal oriented process: Decision-making aims at providing a solution to a given problem/ diIIiculty
beIore a business enterprise. It is a goal-oriented process and provides solutions to problems Iaced by a
business unit.
6. eans and not the end: Decision-making is a means Ior solving a problem or Ior achieving a
target/objective and not the end in itselI.
7. Relates to speciIic problem: Decision-making is not identical with problem solving but it has its roots
in a problem itselI.
8. %ime-consuming activity: Decision-making is a time-consuming activity as various aspects need
careIul consideration beIore taking Iinal decision. For decision makers, various steps are required to be
completed. %his makes decision-making a time consuming activity.
9. Needs eIIective communication: Decision-taken needs to be communicated to all concerned parties Ior
suitable Iollow-up actions. Decisions taken will remain on paper iI they are not communicated to
concerned persons. Following actions will not be possible in the absence oI eIIective communication.
10. Pervasive process: Decision-making process is all pervasive. %his means managers working at all
levels have to take decisions on matters within their jurisdiction.
11. Responsible job: Decision-making is a responsible job as wrong decisions prove to be too costly to the
Organisation. Decision-makers should be matured, experienced, knowledgeable and rational in their
approach. Decision-making need not be treated as routing and casual activity. It is a delicate and
responsible job.
4. Advantages of Decision Making
1. Decision making is the primary Iunction oI management: %he Iunctions oI management starts only
when the top-level management takes strategic decisions. Without decisions, actions will not be
possible and the resources will not be put to use. %hus decision-making is the primary Iunction oI
management.
2. Decision-making Iacilitates the entire management process: Decision-making creates proper
background Ior the Iirst management activity called planning. Planning gives concrete shape to broad
decisions about business objectives taken by the top-level management. In addition, decision-making is
necessary while conducting other management Iunctions such as organising, staIIing, coordinating and
communicating.
3. Decision-making is a continuous managerial Iunction: anagers working at all levels will have to take
decisions as regards the Iunctions assigned to them. Continuous decision making is a must in the case
oI all managers/executives. Follow-up actions are not possible unless decisions are taken.
4. Decision-making is essential to Iace new problems and challenges: Decisions are required to be taken
regularly as new problems, diIIiculties and challenges develop beIore a business enterprise. %his may
be due to changes in the external environment. New products may come in the market, new
competitors may enter the market and government policies may change. All this leads to change in the
environment around the business unit. Such change leads to new problems and new decisions are
needed.
5. Decision-making is a delicate and responsible job: anagers have to take quick and correct decisions
while discharging their duties. In Iact, they are paid Ior their skill, maturity and capacity oI decision-
making. anagement activities are possible only when suitable decisions are taken. Correct decisions
provide opportunities oI growth while wrong decisions lead to loss and instability to a business unit.
5. Steps Involved In Decision Making Process
Decision-making involves a number oI steps which need to be taken in a logical manner. %his is treated as
a rational or scientiIic 'decision-making process' which is lengthy and time consuming. Such lengthy
process needs to be Iollowed in order to take rational/scientiIic/result oriented decisions. Decision-making
process prescribes some rules and guidelines as to how a decision should be taken / made. %his involves
many steps logically arranged. It was Peter Drucker who Iirst strongly advocated the scientiIic method oI
decision-making in his world Iamous book '%he Practice oI anagement' published in 1955. Drucker
recommended the scientiIic method oI decision-making which, according to him, involves the Iollowing
six steps:
1. DeIining / IdentiIying the managerial problem,
2. Analyzing the problem,
3. Developing alternative solutions,
4. Selecting the best solution out oI the available alternatives,
5. Converting the decision into action, and
6. Ensuring Ieedback Ior Iollow-up.
%he Iigure given below suggests the steps in the decision-making process:-


1. IdentiIying the Problem: IdentiIication oI the real problem beIore a business enterprise is the Iirst step
in the process oI decision-making. It is rightly said that a problem well-deIined is a problem halI-
solved. InIormation relevant to the problem should be gathered so that critical analysis oI the problem
is possible. %his is how the problem can be diagnosed. Clear distinction should be made between the
problem and the symptoms which may cloud the real issue. In brieI, the manager should search the
'critical Iactor' at work. It is the point at which the choice applies. Similarly, while diagnosing the real
problem the manager should consider causes and Iind out whether they are controllable or
uncontrollable.
2. Analyzing the Problem: AIter deIining the problem, the next step in the decision-making process is to
analyze the problem in depth. %his is necessary to classiIy the problem in order to know who must take
the decision and who must be inIormed about the decision taken. Here, the Iollowing Iour Iactors
should be kept in mind:
1. Futurity oI the decision,
2. %he scope oI its impact,
3. Number oI qualitative considerations involved, and
4. Uniqueness oI the decision.
3. Collecting Relevant Data: AIter deIining the problem and analyzing its nature, the next step is to obtain
the relevant inIormation/ data about it. %here is inIormation Ilood in the business world due to new
developments in the Iield oI inIormation technology. All available inIormation should be utilised Iully
Ior analysis oI the problem. %his brings clarity to all aspects oI the problem.
4. Developing Alternative Solutions: AIter the problem has been deIined, diagnosed on the basis oI
relevant inIormation, the manager has to determine available alternative courses oI action that could be
used to solve the problem at hand. Only realistic alternatives should be considered. It is equally
important to take into account time and cost constraints and psychological barriers that will restrict that
number oI alternatives. II necessary, group participation techniques may be used while developing
alternative solutions as depending on one solution is undesirable.
5. Selecting the Best Solution: AIter preparing alternative solutions, the next step in the decision-making
process is to select an alternative that seems to be most rational Ior solving the problem. %he alternative
thus selected must be communicated to those who are likely to be aIIected by it. Acceptance oI the
decision by group members is always desirable and useIul Ior its eIIective implementation.
6. Converting Decision into Action: AIter the selection oI the best decision, the next step is to convert the
selected decision into an eIIective action. Without such action, the decision will remain merely a
declaration oI good intentions. Here, the manager has to convert 'his decision into 'their decision'
through his leadership. For this, the subordinates should be taken in conIidence and they should be
convinced about the correctness oI the decision. %hereaIter, the manager has to take Iollow-up steps Ior
the execution oI decision taken.
7. Ensuring Feedback: Feedback is the last step in the decision-making process. Here, the manager has to
make built-in arrangements to ensure Ieedback Ior continuously testing actual developments against the
expectations. It is like checking the eIIectiveness oI Iollow-up measures. Feedback is possible in the
Iorm oI organised inIormation, reports and personal observations. Feed back is necessary to decide
whether the decision already taken should be continued or be modiIied in the light oI changed
conditions.
Various advantages oI decision-making (already explained) are easily 'available when the entire decision-
making process is Iollowed properly. Decisions are Irequently needed in the management process.
However, such decisions should be appropriate, timely and rational. Faulty and hasty decisions are wrong
and even dangerous. %his clearly suggests that various advantages oI decision-making are available only
when scientiIic decisions are taken by Iollowing the procedure oI decision-making in an appropriate
manner.
UNIT II: Theory of Demand
Meanings and Definition of Demand:

%he word demand is so common and Iamiliar with every one oI us that it seems superIluous to deIine it.
%he need Ior precise deIinition arises simply because it is sometimes conIused with other words such as
desire, wish, want, etc.

Demand in economics means a desire to possess a good supported by willingness and ability to pay Ior it.
II your have a desire to buy a certain commodity, say a car, but you do not have the adequate means to
pay Ior it, it will simply be a wish, a desire or a want and not demand. Demand is an eIIective desire, i.e.,
a desire which is backed by willingness and ability to pay Ior a commodity in order to obtain it. In the
words oI Prof. Hibdon:

"Demand means the various quantities oI goods that would be purchased per time period at diIIerent
prices in a given market".

Characteristics of Demand:

%here are thus three main characteristics of demand in economics.

(i) Willingness and ability to pay. Demand is the amount oI a commodity Ior which a consumer has the
willingness and also the ability to buy.

(ii) Demand is always at a price. II we talk oI demand without reIerence to price, it will be meaningless.
%he consumer must know both the price and the commodity. He will then be able to tell the quantity
demanded by him.

(iii) Demand is always per unit of time. %he time may be a day, a week, a month, or a year.

Example:

For instance, when the milk is selling at the rate oI $15.0 per liter, the demand oI a buyer Ior milk is 10
liters a day. II we do not mention the period oI time, nobody can guess as to how much milk we
consume? It is just possible we may be consuming ten liters oI milk a week, a month or a year.

Summing up, we can say that by demand is meant the amount oI the commodity that buyers are able and
willing to purchase at any given price over some given period oI time. Demand is also described as a
schedule oI how much a good people will purchase at any price during a speciIied period oI time.

Law oI Demand:

Definition and Explanation of the Law:

We have stated earlier that demand Ior a commodity is related to price per unit oI time. It is the
experience oI every consumer that when the prices oI the commodities Iall, they are tempted to purchase
more. Commodities and when the prices rise, the quantity demanded decreases. %here is, thus, inverse
relationship between the price oI the product and the quantity demanded. %he economists have named this
inverse relationship between demand and price as the law of demand.

Statement of the Law:

Some well known statements oI the law oI demand are as under:

According to Prof. Samuelson:

"%he law oI demand states that people will buy more at lower prices and buy less at higher prices, other
things remaining the same".

E. Miller writes:

"Other things remaining the same, the quantity demanded oI a commodity will be smaller at higher
market prices and larger at lower market prices".

"Other things remaining the same, the quantity demanded increases with every Iall in the price and
decreases with every rise in the price".

In simple we can say that when the price oI a commodity rises, people buy less oI that commodity and
when the price Ialls, people buy more oI it ceteris paribus (other things remaining the same). Or we can
say that the quantity varies inversely with its price. %here is no doubt that demand responds to price in the
reverse direction but it has got no uniIorm relation between them. II the price oI a commodity Ialls by 1,
it is not necessary that may also increase by 1. %he demand can increase by 1, 2, 10, 15, as the
situation demands. %he Iunctional relationship between demanded and the price oI the commodity can be
expressed in simple mathematical language as under:

Formula For Law of Demand:

"d
x
f (P
x
, M, P
o
, T,..........)
Here:
Qd
x
A quantity demanded oI commodity x.
I A Iunction oI independent variables contained within the parenthesis.
P
x
Price oI commodity x.
P
o
Price oI the other commodities.
% %aste oI the household.

%he bar on the top oI , P
o
, and % means that they are kept constant. %he demand Iunction can also be
symbolized as under:

"d
x
f (P
x
) ceteris paribus

Ceteris Paribus. In economics, the term is used as a shorthand Ior indicating the eIIect oI one economic
variable on another, holding constant all other variables that may aIIect the second variable.

Schedule of Law of Demand:
%he demand schedule oI an individual Ior a commodity is a Iist or table oI the diIIerent amounts oI the
commodity that are purchased the market at diIIerent prices per unit oI time. An individual demand
schedule Ior a good say shirts is presented in the table below:
Individual Demand Schedule for Shirts:

(In Dollars)
Price per shirt 100 80 60 40 20 10
"uantity demanded per year "
dx
5 7 10 15 20 30

According to this demand schedule, an individual buys 5 shirts at $100 per shirt and 30 shirts at $10 per
shirt in a year.

Law of Demand Curve/Diagram:
Demand curve is a graphic representation oI the demand schedule. According to Lipsey:
"%his curve, which shows the relation between the price oI a commodity and the amount oI that
commodity the consumer wishes to purchase is called demand curve".
It is a graphical representation oI the demand schedule.



In the Iigure (4.1), the quantity. demanded oI shirts in plotted on horizontal axis OX and "price is
measured on vertical axis OY. Each price- quantity combination is plotted as a point on this graph. II we
join the price quantity points a, b, c, d, e and I, we get the individual demand curve Ior shirts. %he DD
/
demand curve slopes downward Irom leIt to right. It has a negative slope showing that the two variables
price and quantity work in opposite direction. When the price oI a good rises, the quantity demanded
decreases and when its price decreases, quantity demanded increases, ceteris paribus.

Assumptions of Law of Demand:
According to Prof. Stigler and Boulding:
%here are three main assumptions oI the Law:
(i) %here should not be any change in the tastes oI the consumers Ior goods (%).
(ii) %he purchasing power oI the typical consumer must remain constant ().
(iii) %he price oI all other commodities should not vary (P
o
).

Example of Law of Demand:

II there is a change, in the above and other assumptions, the law may not hold true. For example,
according to the law oI demand, other things being equal quantity demanded increases with a Iall in price
and diminishes with rise to price. Now let us suppose that price oI tea comes down Irom $40 per pound to
$20 per pound. %he demand Ior tea may not increase, because there has taken place a change in the taste
oI consumers or the price oI coIIee has Iallen down as compared to tea or the purchasing power oI the
consumers has decreased, etc., etc. From this we Iind that demand responds to price inversely only, iI
other thing remains constant. Otherwise, the chances are that, the quantity demanded may not increase
with a Iall in price or vice-versa.

Demand, thus, is a negative relationship between price and quantity.

In the words oI Bilas: "Other things being equal, the quantity demanded per unit oI time will be greater,
lower the price, and smaller, higher the price".

Limitations/Exceptions of Law of Demand:

%hough as a rule when the prices oI normal goods rise, the demand them decreases but there may be a
Iew cases where the law may not operate.

(i) Prestige goods: %here are certain commodities like diamond, sports cars etc., which are purchased as a
mark oI distinction in society. II the price oI these goods rise, the demand Ior them may increase instead
oI Ialling.

(ii) Price expectations: II people expect a Iurther rise in the price particular commodity, they may buy
more in spite oI rise in price. %he violation oI the law in this case is only temporary.
(3) Ignorance of the consumer: II the consumer is ignorant about the rise in price oI goods, he may buy
more at a higher price.

(iv) Giffen goods: II the prices oI basic goods, (potatoes, sugar, etc) on which the poor spend a large part
oI their incomes declines, the poor increase the demand Ior superior goods, hence when the price oI
GiIIen good Ialls, its demand also Ialls. %here is a positive price eIIect in case oI GiIIen goods.

Importance of Law of Demand:

(i) Determination of price. %he study oI law oI demand is helpIul Ior a trader to Iix the price oI a
commodity. He knows how much demand will Iall by increase in price to a particular level and how much
it will rise by decrease in price oI the commodity. %he schedule oI market demand can provide the
inIormation about total market demand at diIIerent prices. It helps the management in deciding whether
how much increase or decrease in the price oI commodity is desirable.

(ii) Importance to Finance Minister. %he study oI this law is oI great advantage to the Iinance minister.
II by raising the tax the price increases to such an extend than the demand is reduced considerably. And
then it is oI no use to raise the tax, because revenue will almost remain the same. %he tax will be levied at
a higher rate only on those goods whose demand is not likely to Iall substantially with the increase in
price.

(iii) Importance to the Farmers. Goods or bad crop aIIects the economic condition oI the Iarmers. II a
goods crop Iails to increase the demand, the price oI the crop will Iall heavily. %he Iarmer will have no
advantage oI the good crop and vice-versa.

Summing up we can say that the limitations or exceptions oI the law oI demand stated above do not
IalsiIy the general law. It must operate.

Individual's and Market Demand for a Commodity:

Individual's Demand for a Commodity:

Definition and Explanation:

%he individuals demand for a commodity is the amount oI a commodity which the consumer is willing
to purchase at any given price over a speciIied period oI time".

%he individual's demand Ior a commodity varies inversely price ceteris paribus. As the price oI a goods
rises, other things remaining the same, the quantity demanded decreases and as the price Ialls, the
quantity demanded increases.

Price (p) is here an independent variable ad quantity (q) dependent variable.

Individual's Demand Schedule:

%he demand schedule oI an individual Ior a commodity is a list or table oI the diIIerent amounts oI the
commodity that are purchased the market at diIIerent prices per unit oI time. An individual demand
schedule Ior a good say shirts is presented in the table below:

Individual Demand Schedule for Shirts:

Price Per Shirt ($) 100 80 60 40 20 10
"uantity Demanded Per Year "
dx
5 7 10 15 20 30

According to this demand schedule, an individual buys 5 shirts at $100 per shirt and 30 shirts at $10 per
shirt in a year.

Individual's Demand Curve:

Demand curve is a graphic representation oI the demand schedule. According to Lipsey:

"%he curve, which shows the relation between the price oI a commodity and the amount oI that
commodity the consumer wishes to purchase is called demand curve".

It is a graphical representation oI the demand schedule.



In the Iigure (4.1), the quantity. demanded oI shirts in plotted on horizontal axis OX and price is
measured on vertical axis OY. Each price quantity combination is plotted as a point on this graph. II we
join the price quantity points a, b, c, d, e and I, we get the individual demand curve Ior shirts.

%he DD
/
demand curve slopes downward Irom leIt to right. It has a negative slope showing that the two
variables price and quantity work in opposite direction. When the price oI a good rises, the quantity
demanded decreases and when its price decreases, quantity .demanded increases, ceteris paribus.

Market Demand for a Commodity:

Definition and Explanation:
%he market demand Ior a commodity is obtained by adding up the total quantity demanded at various
prices by all the individuate over a speciIied period oI time in the market It is described as the horizontal
summation oI the individuals demand Ior a commodity at various possible prices in market.

In a market, there are a number oI buyers Ior a commodity at each price. In order to avoid a lengthy
addition process, we assume here that there are only Iour buyers Ior a commodity who purchase diIIerent
amounts oI the commodity at each price.

Market Demand Schedule:
%he horizontal summation oI individuals demand Ior a commodity will be the market demand Ior a
commodity as is illustrated in the Iollowing schedule:

A market Demand Schedule in a Four Consumer Market:

Price
($)

"uantity
Demanded
"uantity
Demanded
"uantity
Demanded
"uantity
Demanded
Total "uantity
Demanded Per
Week (in
thousands)

First Buyer

Second Buyer %hird Buyer Fourth
Buyer
10
8
6
4
10
15
25
40
13
20
30
35
6
9
10
15
11
16
20
30
40
60
85
120
2 60 50 30 40 180


In the above schedule, the amount oI commodity demanded by Iour buyers (which we assume constitute
the entire market) diIIers Ior each price When the price oI a commodity is $10, the total quantity
demanded is 4C thousand units per week. At price oI $2, the total quantity demanded increases to 180.
thousand units.
.
Market Demand Curve:

arket demand curve Ior a Commodity is the horizontal sum oI individual demand curves oI ail the
buyers in a market. %his is illustrated with the help oI the market demand schedule given above.



%he market demand curve DD
/
Ior a commodity, like the individual demand curve is negatively sloped,
(see Iigure 4.2). It shows that under the assumptions (ceteris paribus) other things remaining the same,
there is an inverse relationship between the quantity demanded and its price.

At price oI $10, the quantity demanded in the market is 40 thousand units. At price oI $2.0. it increases to
180 thousand units. In. other words, the lower the price oI the good X, the greater is the demand Ior it
ceteris paribus.

Movement Vs Shifts of Demand Curve:

Changes in demand Ior a commodity can be shown through the demand curve in two ways:

(1) ovement Along the Demand Curve and (2) ShiIts oI the Demand Curve.

(1) Movement along the Demand Curve:

Demand is a multivariable Iunction. II income and other determinants oI demand such as tastes oI the
consumers, changes in prices oI related goods, income distribution, etc., remain constant and there is a
change only in price oI the commodity, then we move along the same demand curve.

In this case, the demand curve remains unchanged. When, as a result oI change in price, the quantity
demanded increases or decreases, it is technically called extension and contraction in demand.

%he demand curve, which represents various price quantity has a negative slope. Whenever there is a
change in the quantity demanded oI a good due to change, in its price, there is a movement Irom one point
price quantity combination to another on the
same demand curve. Such a movement Irom one point price quantity combination to another along the
same demand curve is shown in Iigure (4.3).

Diagram/Figure:



Here the price oI a commodity Ialls Irom $8 to $2. As a result, thereIore, the quantity demanded increases
Irom 100 units to 400 units per unit oI time. %here is extension in demand by 300 units. %his movement is
Irom one point price quantity combination (a) to another point (b) along a given demand curve. On the
other hand, iI the price oI a good rises Irom $2 to $8, there is contraction in demand by 300 units.

We, thus, see that as a result oI change in the price oI a good, the consumer moves along the given
demand curve. %he demand curve remains the same and does not change its position. %he movement
along the demand curve is designated as change in quantity demanded.

(2) Shifts in Demand Curve:

Demand, as we know, is determined by many Iactors. When there is a change in demand due to one or
more than one Iactors other than price, results in the shiIt oI demand curve.

For example, iI the level oI income in community rises, other Iactors remaining the same, the demand Ior
the goods increases. Consumers demand more goods at each price per period oI me (rise or Increase in
demand). %he demand curve shiIts upward Irom he original demand curve indicating that consumers at
each price purchase more units oI commodity per unit oI time.

II there is a Iall in the disposable income oI the consumers or rise in the prices oI close substitute oI a
good or decline in consumer taste or non-availability oI good on credit, etc, etc., there is a reduction in
demand (Iall or decrease in demand). %he Iall or decrease in demand shiIts the demand curve Irom the
original demand curve to the leIt. %he lower demand curve shows that consumers are able and willing to
buy less oI the good at each price than beIore.

Schedule:

P
dx
($) "
dx
Rise in "
dx
Fall in "
dx

12 100 300 50
6 250 500 200
4 500 600 300

Diagram/Figure:



In this Iigure, (4.4) the original demand curve is DD
/
.

At a price oI $12 per unit, consumers purchase 100 units. When price Ialls to$4 per unit, the quantity
demanded increases to 500 units per unit oI time. Let us assume now that level oI income increases in a
community. Now consumers demand 300 units oI the commodity at price oI $12 per unit and 600
at price oI $4 per unit.

As a result, there is an upward shiIt oI the demand curve DD
2
. In case the community income Ialls, there
is then decrease in demand at price oI $12 per unit. %he quantity demanded oI a good Ialls to 50 units. It
is 300 units at price oI $4 unit per period oI time. %here is a downward shiIt oI the demand to the leIt oI
the original demand curve.

Summing Up:
(i) Extension in demand is due to reduction in price.
(ii) Increase in demand occurs due to changes in Iactors other than price.
(iii) Contraction in demand is the result oI a rise in the price commodity.
(iv) A decrease in demand Iollows a change in Iactors other than price.
(v) Changes in demand both increase and decrease are represent shiIts in the demand curve.
(vi) Changes in the quantity demanded are represented by move along the same demand curve.

Non Price Factors or Shifts Factors Causing Changes in Demand:

Determinants of Demand:

While explaining the law oI demand, we have stated that, other things remaining the same (cetris
paribus), the demand Ior a commodity inversely with price per unit oI time. %he other things, have an
important bearing on the demand Ior a commodity.

%hey bring about changes in demand independently oI changes in price. %hese non-price factors shift
factors or determinants which inIluence demand are as Iollow:

(i) Changes in population: II the population oI a country increase account oI immigration or through
high birth rate or on account oI these Iactors, the demand Ior various kinds oI goods will increase even the
prices remains the same. %he demand curve will shiIt upward to the right.

%he nature oI the commodities .demanded will depend up to taste oI the consumers. II due to high net
production rate, the percentage oI children to the total population increases in a country, there will greater
demand Ior toys, children Iood, etc. Similarly, iI the percent aged people to the total population increases,
the demand Ior walking sticks, artiIicial teeth, invalid chairs, etc, will increase.

(ii) Changes in tastes: Demand Ior a commodity may change due to changes in tastes and Iashions. For
example, people develop a taste Ior coIIee. %here is then a decrease in the demand Ior tea. %he de curve
Ior tea shiIts to the leIt oI the original demand curve.

Similarly women's Iashions are usually ever changing. Sometime they keep hair and sometime short. So,
whenever there is a change in their hair style, the demand Ior hairpins, hair nets, etc. is greatly aIIected.

(iii) Changes in income: When the income oI consumers increases generally leads to an increase in the
demand Ior some commodities and a decrease in the demand Ior other commodities. For example, when
income oI people increases, they begin to spend money on those which were previously regarded by them
as luxuries, or semi-luxuries and reduce the expenditure on inIerior goods.

%ake the case oI a man whose income has increased Irom $1000 to $20,000 per month. His consumption
oI wheat will go down because he now spends more money on the superior Iood such as cake, Iish, daily
products, Iruits, etc., etc.

(iv) Changes in the distributions of wealth: II an equal distribution oI wealth is brought about in a
country, then there will be less demand Ior expensive luxuries goods. %here will be more demand Ior
necessaries and comIort items.

(v) Changes in the price of substitutes: iI the price oI a particular commodity rises, people may stop
Iurther purchase oI that commodity and spend money on its substitute which is available at a lower price.
%hus we Iind, a change in demand can also be brought about by a change in the price oI the substitute.

(vi) Changes in the state of trade: %he total quantity oI goods demanded is also aIIected by the cyclical
Iluctuations in economic activities. II the trade is prosperous, the demand Ior raw material, machinery,
etc., increases. II on the other hand, the trade period is dull, the demand Ior, producer's goods will Iail
sharply as compared to the demand Ior consumer goods.

(vii) Climate and weather conditions: %he climate and weather conditions have an important bearing on
the demand oI a commodity. For instance, the consumer's demand Ior woolen clothes increases in winter
and decreases in summer.

Slope of the Demand Curve:
Demand Curve is Negatively Sloped:

%he demand curve generally slopes downward Irom leIt to right. It has a negative slope because the two
important variables price and quantity work in opposite direction. As the price oI a commodity decreases,
the quantity demanded increases over a speciIied period oI time, and vice versa, other , things remaining
constant.

%he Iundamental reasons Ior demand curve to slope downward are as Iollows:

(i) Law of diminishing marginal utility: %he law oI demand is based on the law oI diminishing marginal
utility. According to the cardinal utility approach, when a consumer purchases more units oI a
commodity, its marginal utility declines. %he consumer, thereIore, will purchase more units oI that
commodity only iI its price Ialls. %hus a decrease in price brings about an increase, in demand. %he
demand curve, thereIore, is downward sloping.

(ii) Income effect: Other things being equal, when the price oI a commodity decreases, the real income or
the purchasing power oI the household increases. %he consumer is now in a position to purchase more
commodities with the same income. %he demand Ior a commodity thus increases not only Irom the
existing buyers but also Irom the new buyers who were earlier unable to purchase at higher price. When
at a lower price, there is a greater demand Ior a commodity by the households, the
demand curve is bound to slope downward Irom leIt to right.

(iii) Substitution effect: %he demand curve slopes downward Irom leIt to right also because oI the
substitution eIIect. For instance, the price oI meat Ialls and the prices oI other substitutes say poultry and
beeI remain constant. %hen the households would preIer to purchase meat because it is now relatively
cheaper. %he increase in demand with a Iall in the price oI meat will move the demand curve downward
Irom leIt to right.

(iv) Entry of new buyers: When the price oI a commodity Ialls, its demand not only increases Irom the
old buyers but the new buyers also enter the market. %he combined result oI the income and substitution
eIIect is that demand extends, ceteris paribus, as the .price Ialls. %he demand curve slopes downward
Irom leIt to right.

Meanings of Supply and Stock:

Definition of Supply:

Supply is oI the scarce goods. It is the amount oI a commodity that sellers are able and willing to oIIer
Iore sale at diIIerent price per unit oI time.
In the words oI Meyer: Supply is a schedule oI the amount oI a good that would be oIIered Iore sale at
all possible price at any period oI time; e.g., a day, a week, and so on.
DeIinition oI Stock:
Stock is meant the total quantity oI a commodity this exists in a market and can be oIIered Ior sale at a
short notice".
Difference/Distinction Between Supply and Stock:

Here it seems necessary that the meaning oI the term supply` and stock` may be made clear as they are
oIten conIused by the readers. Supply reIers to that quantity oI the commodity which is actually brought
into the market Iore sale at a given price per unit oI time. While Stock is meant the total quantity oI a
commodity this exists in a market and can be oIIered Ior sale at a short notice.
%he supply and stock oI a commodity in the market may or may not be equal iI the commodity is
perishable, like vegetables, Iruits, Iish, etc; then the supply and stock is generally the same. But in case oI
a product Iind that the price oI his product is low as compared to its cost oI production, he tries to
withhold the entire or a part oI a stock. In case oI a Iavorable price, the producer may dispose oI large
quantities or the entire stock oI his commodity; it will all depend upon his own valuation oI the
commodity at that particular time.
Law of Supply:

Definition of Law of Supply:
%here is direct relationship between the price oI a commodity and its quantity oIIered Iore sale over a
speciIied period oI time. When the price oI a goods rises, other things remaining the same, its quantity
which is oIIered Ior sale increases as and price Ialls, the amount available Ior sale decreases. %his
relationship between price and the quantities which suppliers are prepared to oIIer Ior sale is called the
law of supply.
Explanation of Law of Supply:
%he law of supply, in short, states that ceteris paribus sellers supply more goods at a higher price than
they are willing at a lower price.
Supply Function:
%he supply function is now explained with the help oI a schedule and a curve.
Market Supply Schedule:
Market Supply Schedule of a Commodity:
(In Dollars)
P
x
4 3 2 1
"
x
S
100 80 60 40

In the table above, the produce are able and willing to oIIer Ior sale 100 units oI a commodity at price oI
$4. As the price Ialls, the quantity oIIered Ior sale decreases. At price oI $1, the quantity oIIered Ior sale
is only 40 units.
Law of Supply Curve/Diagram:
%he market supply data oI the commodity x as shown in the supply schedule is now presented
graphically.


In the Iigure (5.1) price is plotted on the vertical axis OY and the quantity supplied on the horizontal axis
OX. %he Iour points d, c, b, and a show each price quantity combination. %he supply curve SS
/
slopes
upward Irom leIt to right indicating that less quantity is oIIered Ior sale at lower price and more at
higher prices by the sellers not supply curve is usually positively sloped.
Formula for Law of Supply/Supply Function:
%he supply Iunction can also be expressed in symbols.

"
x
S
d (Px Tech, S
i
, F
n
, X,........)
Here:
Q
x
s
Quantity supplied oI commodity x by the producers.
4 Function oI.
P
x
Price oI commodity x.
%ech %echnology.
S Supplies oI inputs.
F Features oI nature.
X %axes/Subsidies.
Bar on the top oI last Iour non-price Iactors indicates that these variables also aIIect the supply but
they are held constant.
Example oI Law oI Supply:
%he law oI supply is based on a moving quantity oI materials available to meet a particular need. Supply
is the source oI economic activity. Supply, or the lack oI it, also dictates prices. Cost oI scarce supply
goods increase in relation to the shortages. Supply can be used to measure demand. Over supply results in
lack oI customers. An over supply is oIten a loss, Ior that reason. Under supply generates a demand in the
Iorm oI orders, or secondary sales at higher prices.
II ten people want to buy a pen, and there's only one pen, the sale will be based on the level oI demand
Ior the pen. %he supply Iunction requires more pens, which generates more production to meet demand.
Assumptions oI Law oI Supply:
(i) Nature of Goods. II the goods are perishable in nature and the seller cannot wait Ior the rise in price.
Seller may have to oIIer all oI his goods at current market price because he may not take risk oI getting
his commodity perished.

(ii) Government Policies. Government may enIorce the Iirms and producers to oIIer production at
prevailing market price. In such a situation producer may not be able to wait Ior the rise in price.

(iii) Alternative Products. II a number oI alternative products are available in the market and customers
tend to buy those products to IulIill their needs, the producer will have to shiIt to transIorm his resources
to the production oI those products.

(iv) Squeeze in Profit. Production costs like raw materials, labor costs, overhead costs and selling and
administration may increase along with the increase in price. Such situations may not allow producer to
oIIer his products at a particular increased price.

Limitations/Exceptions of Law of Supply:

Exceptions that aIIect law oI supply may include:

(i) Ability to move stock.
(ii) Legislation restricting quantity.
(iii) External Iactors that inIluence your industry.

Importance oI Law oI Supply:
(i) Supply responds to changes in prices diIIerently Ior diIIerent goods, depending on their elasticity or
inelasticity. Goods are elastic when a modest change in price leads to a large change in the quantity
supplied. In contrast, goods are inelastic when a change in price leads to relatively no response to the
quantity supplied. An example oI an elastic good would be soIt drinks, whereas an example oI an inelastic
service would be physicians' services. Producers will be more likely to want to supply more inelastic
goods such as gas because they will most likely proIit more oII oI them.
(ii) Law oI supply is an economic principle that states that there is a direct relationship between the price
oI a good and how much producers are willing to supply.
(iii) As the price oI a good increases, suppliers will want to supply more oI it. However, as the price oI a
good decreases, suppliers will not want to supply as much oI it. For producers to want to produce a good,
the incentive oI proIit must be greater than the opportunity cost oI production, the total cost oI producing
the good, which includes the resources and value oI the other goods that could have been produced
instead.

(iv) Entrepreneurs enter business ventures with the intention oI making a proIit. A proIit occurs when the
revenues Irom the goods a producer supplies exceeds the opportunity cost oI their production. However,
consumers must value the goods at the price oIIered in order Ior them to buy them. %hereIore, in order Ior
a consumer to be willing to pay a price Ior a good higher than its cost oI production, he or she must value
that good more than the other goods that could have been produced instead. So supplier's proIits are
dependent on consumer demands and values. However, when suppliers do not earn enough revenue to
cover the cost oI production oI the good, they incur a loss. Losses occur whenever consumers value a
good less than the other goods that could have been produced with the same resources.
Determinants of Supply:

%here are Iour important Determinants of Supply as under:

(i) Technology changes. %echnology helps a producer to minimize his cost oI production.

(ii) Resource supplies. %he producer also has to pay Ior other resources such as raw materials and labor.
iI his money is short on supplying a certain number oI products because oI an increase in resource
supplies, then he has to reduce his supply.

(iii) Tax/ Subsidy. A producer aims to maximize his proIit, but an increase in tax will only increase his
expenses, decreasing his capacity to buy resource supplies and Iorcing him to reduce his supply.

(iv) Price of other goods produced. A producer may not only produce on product but other products as
well. A producer's money is limited and iI he increases his supply in one product, he would have to
decrease his supply in the other product, no unless his sales increase.

%hus:
"
x
s
d (P
x
) Ceteris Paribus
Ceteris Paribus. In economics, the term is used as a shorthand Ior indicating the eIIect oI one economic
variable on another, holding constant all other variables that may aIIect the second variable.
Difference between Shift in Supply Curve and Movement:

Movement Along with the Same Supply Curve:

While explaining the law oI supply we have stated that as price rise, the quantity supplied increases and
as price Ialls the quantity supplied increases and as price provided other things remain the same. %his
change in the quantity supplied oI a commodity is a movement oI one price quantity combination to
another on the same supply curve. Such a movement at varying prices is now illustrated with the help oI
the supply curve given in Iigure 5.2.
Diagram/Figure:


Figure of Movement:
In the above Iigure (5.2) at price "a%" ($3.00), "a%" 50 units quantity is supplied. When price rises to dL
($7.0), the quantity supplied by the producers increases to OL (110 units). %he change in quantity
supplied at varying prices is reIerred as movement along the same supply curve.
Shifts in Supply Curve:
Shifts in supply curve means changes in supply. While explaining the law oI supply, we have stated that
that other things remaining the same (ceteris paribus) the amount oI the commodity oIIered Iore sale
increases with the rise in price and decreases with a Iall in price. When there is an increase in supply due
to one or more than one non-price Iactor (which was held constant) such as production techniques,
resource prices, changes in the price oI other commodities, etc., there is a rise in supply. %he entire supply
curve shiIts to the right oI original supply curve indicating that more quantity is oIIered Iore sale at the
same price per time period.
II due to one or a combination oI non-price Iactors, less quantity is brought into the market Iore sale at
each price, the supply is said to have Iallen. In case oI Iall in supply, the supply curve shiIts to the leIt oI
the original supply curve. %he rise and Iall oI supply curve (shiIts in supply curve) is explained with the
help oI an imaginary schedule and a diagram.
Schedule oI ShiIts in Supply Curve:
Price per
shirt
(Dollars )
Original
quantitySupplied
per Week
Rise in
supply
Fall in
supply

50 200 320 140
40 160 200 100
30 100 150 70
20 39 100 15

Figure of Shifts in Supply Curve:



In the Iigures (5.3) SS
/
in the original supply curve S
2
S
2
to the right oI the original supply curve shows an
increase in the quantity supplied at each price. S
3
S
3
supply curve to the leIt oI original supply curve to the
leIt oI original supply curve indicates a decrease in supply at each price over a speciIied period oI time.
Determinants of Supply:
When the supply of the commodity rises or falls due to non-price determinants, the supply is said
to have increased supply or decreased supply. The increases or decrease or the rise or fall in supply
may take place on account of various factors.
%hey are brieIly stated as below:

(i) Changes in Factor Price. %he rise oI Iall in supply may take place due to changes in the cost oI
production oI a commodity. II the prices oI various Iactor oI production used in the production oI a
particular commodity increase oI it total cost oI production. %here will be reduction in the supply oI that
commodity at each price because the amount demanded decreases with a rise in price. Conversely, iI the
prices oI the various Iactors oI production Iall down, it will result in lowering the cost oI production and
so an increase in the supply on varying prices.

(ii) Changes in Technique. %he supply oI a commodity may also be aIIected by progress in technique. II
an improvement in technique takes place in a particular industry, it will help in reducing its cost oI
production. %his will result in greater production and so an increase in the supply oI the commodity. %he
supply curve will shiIts to the right oI the original supply curve.

(iii) Improvement in the Means of Transport. %he supply oI the commodity may also increase due to
improvement in the means oI communication and transport. II the means oI transport are cheep and Iast,
then supply oI the commodity can be increased at a short notice at lower price.

(iv) Climatic Changes in case of Agricultural Products. %he supply oI agricultural products is directly
aIIected by the weather conditions and the use oI the better methods oI production. II rain is timely
plentiIul well-distributed; and improve methods oI cultivation are employed then other things remaining
the same, there will be bumper crops. It would then be possible to increase the supply oI the agriculture
products.

(v) Political Changes. %he increase or decrease in supply may also place due to political disturbances in a
country. II country wages wars against another country or some kind oI political disturbances take place
just as we had at the time oI partition, then the channels oI production are disorganized. It results in the
decrease oI certain goods the supply curve shiIts to the leIt oI originals curve.

(vi) Taxation Policy. II a government levies heavy taxes on the import oI particular commodities, then
the supply oI these commodities is reduced at each price. %he supply curve shiIts to the leIt .conversely iI
the taxes on output in the country are low and government encourages the import oI Ioreign commodities,
then the supply can be increased easily. %he supply curve shiIts to the right oI originals supply curve.

(vii) Goals of firms. II the Iirms expect higher proIits in the Iuture, they will take the risk and produce
goods on large scale resulting in larger supply oI the commodities. %he supply curve shiIts to the right.

Meaning of Price Elasticity of Demand:

%he law oI demand is straight Iorward. It tells us when the price oI a good rises, its quantity demanded
will Iall, all other things held constant. %he law dose not indicate as to how much the quantity demanded
will Iall with the rise in price or how much responsive demand is to a rise price. %he economists here use
and measure the quantity demanded to a change in price by the concept oI elasticity oI demand.
What is Price Elasticity of Demand?
DeIinition:
!rice elasticity of demand measures the degree oI responsiveness oI the quantity demanded oI a good to
a change in its price. It is also deIined as:
"%he ratio oI proportionate change in quantity demanded caused by a given proportionate change in
price".
Formula for Calculation:
Price elasticity oI demand is computed by dividing the percentage change in quantity demanded oI a
good by the percentage change in its price.
Symbolically price elasticity oI demand is expressed as under:
E
d
Percentage Change in "uantity Demanded
Percentage Change in Price
Simple Iormula Ior calculating the price elasticity oI demand:
E
d
A"
AP

Here:
E
d
stands Ior price elasticity oI demand.
Q stands Ior original quantity.
P stands Ior original price.
A stands Ior a small change.
Example:

%he price elasticity oI demand tells us the relative amount by which the quantity demanded will change in
response to a change in the price oI a particular good. For example, iI there is a 10 rise in the price oI a
tea and it leads to reduction in its demanded by 20, the price elasticity oI demand will be:

E
d
-20
+10
E
d
-2.0
Degrees of Elasticity of Demand:

We have stated demand Ior a product is sensitive or responsive to price change. %he variation in demand
is, however, not uniIorm with a change in price. In case oI some products, a small change in price leads to
a relatively larger change in quantity demanded.
Elastic and Inelastic Demand:
For example, a decline oI 1 in price leads to 8 increase in the quantity demanded oI a commodity. In
such a case, the demand is said to elastic. %here are other products where the quantity demanded is
relatively unresponsive to price changes. A decline oI 8 in price, Ior example, gives rise to 1 increase
in quantity demanded. Demand here is said to be inelastic.
%he terms elastic and inelastic demand do not indicate the degree oI responsiveness and
unresponsiveness oI the quantity demanded to a change in price.
%he economists thereIore, group various degrees of elasticity of demand into five categories.
(1) Perfectly Elastic Demand:
A demand is perIectly elastic when a small increase in the price oI a good its quantity to zero. PerIect
elasticity implies that individual producers can sell all they want at a ruling price but cannot charge a
higher price. II any producer tries to charge even one penny more, no one would buy his product.
People would preIer to buy Irom another producer who sells the good at the prevailing market price oI $4
per unit. A perIect elastic demand curve is illustrated in Iig. 6.1.
Diagram:


It shows that the demand curve DD
/
is a horizontal line which indicates that the quantity demanded is
extremely (inIinitely) response to price. Even a slight rise in price (say $4.02), drops the quantity
demanded oI a good to zero. %he curve DD
/
is inIinitely elastic. %his elasticity oI demand as such is equal
to inIinity.
(2) Perfectly Inelastic Demand:
When the quantity demanded oI a good dose not change at all to whatever change in price, the demand is
said to be perIectly inelastic or the elasticity oI demand is zero.
For example, a 30 rise or Iall in price leads to no change in the quantity demanded oI a good.
E
d
0
30
E
d
0
In Iigure 6.2 a rise in price Irom OA to OC or Iall in price Irom OC to OA causes no change (zero
responsiveness) in the amount demanded.

E
d

0
Ap E
d
0
(3) Unitary Elasticity of Demand:
When the quantity demanded oI a good changes by exactly the same percentage as price, the demand is
said to has a unitary elasticity.
For example, a 30 change in price leads to 30 change quantity demand 30 / 30 1.
One or a one percent change in price causes a response oI exactly a one percent change in the quantity
demand.

In this Iigure (6.3) DD
/
demand curve with unitary elasticity shows that as the price Ialls Irom OA to OC,
the quantity demanded increases Irom OB to OD. On DD
/
demand curve, the percentage change in price
brings about an exactly equal percentage in quantity at all points a, b. %he demand curve oI elasticity is,
thereIore, a rectangular hyperbola.
E
d
Aq
Ap E
d
1
(4) Elastic Demand:
II a one percent change in price causes greater than a one percent change in quantity demanded oI a
good, the demand is said to be elastic.
Alternatively, we can say that the elasticity oI demand is greater than. For example, iI price oI a good
change by 10 and it brings a 20 change in demand, the price elasticity is greater than one.
E
d

20
10 E
d
2

In Iigure (6.4) DD
/
curve is relatively elastic along its entire length. As the price Ialls Irom OA to OC, the
demand oI the good extends Irom OB to ON i.e., the increase in quantity demanded is more than
proportionate to the Iall in price.
E
d
Aq
Ap E
d
> 1
(5) Inelastic Demand:
When a change in price causes a less than a proportionate change in quantity demand, demand is said to
be inelastic.
%he elasticity oI a good is here less than I or less than unity. For example, a 30 change in price leads to
10 change in quantity demanded oI a good, then:
E
d
10
30
E
d
1
3 E
d
< 1

In Iigure (6.5) DD
/
demand curve is relatively inelastic. As the price Iall Irom OA to OC, the quantity
demanded oI the good increases Irom OB to ON units. %he increase in the quantity demanded is here less
than proportionate to the Iall in price.
Note: It may here note that the slope oI a demand curve is not a reliable indicator oI elasticity. A Ilat
slope oI a demand curve must not mean elastic demand. Similarly, a steep slope on demand curve must
not necessarily mean inelastic demand.
%he reason is that the slope is expressed in terms oI units oI the problem. II we change the units oI
problem, we can get a diIIerent slope oI the demand curve. %he elasticity, on the other hand, is the
percentage change in quantity demanded to the corresponding percentage change in price.
Measurement of Price Elasticity of Demand:
%here are three methods oI measuring price elasticity oI demand:

(1) %otal Expenditure ethod.
(2) Geometrical ethod or Point Elasticity ethod.
(3) Arc ethod.
%hese three methods are now discussed in brieI:

(1) Total Expenditure Method/Total Revenue Method:
DeIinition, Schedule and Diagram:
%he price elasticity can be measured by noting the changes in total expenditure brought about by changes
in price and quantity demanded.
(i) When with a percentage Iall in price, the quantity demanded increases so
much that it results in the increase in total expenditure, the demand is
said to be elastic (E
d
~ 1).

For Example:

Price Per Unit ($) "uantity Demanded Total Expenditure ($)
20 10 Pens 200.0
10 30 Pens 300.0



%he Iigure (6.6) shows that at price oI $20 per pen, the quantity demanded is ten pens, the total
expenditure OABC ($200). When the price Ialls down to $10, the quantity demanded oI pens is thirty.
%he total expenditure is OEFG ($300).

Since OEFG is greater than OABC, it implies that change in quantity demanded is proportionately more
than the change in price. Hence the demand is elastic (more than one) E
d
~ 1.

(ii) When a percentage Iall in price raises the quantity demanded so much as to
leave the total expenditure unchanged, the elasticity oI demand is said to be
unitary (E
d
1).

For Example:

Price Per Pen ($) "uantity Demanded Total Expenditure ($)
10 30 300
5 60 300


%he Iigure (6.7) shows that at price oI $10 per pen, the total expenditure is OABC ($300). At a lower
price oI $5, the total expenditure is OEFG ($300).

Since OABC OEFG, it implies that the change in quantity demanded is proportionately equal to change
in price. So the price elasticity oI demand is equal to one, i.e., E
d
1.

(iii) When a percentage Iall in price raises the quantity demanded oI a good so as to cause the total
expenditure to decrease, the demand is said to be inelastic or less than one, i.e., E
d
1.

For Example:

Price Per Pen ($) "uantity Demanded Total Expenditure ($)
5 60 300
2 100 200



In the Iig (6.8) at a price oI $5 per pen the quantity demanded is 50 pens. %he total expenditure is OABC
($300). At a lower price oI $2, the quantity demanded is 100 pens.

%he total expenditure is OEFG ($200). Since OEFG is smaller than OABC, this implies that the change in
quantity demanded is proportionately less than the change in price. Hence price elasticity oI demand is
less than one or inelastic.

Note:
As the demand curve slopes downward, thereIore, the coefficient of price elasticity of demand is always
negative. %he economists Ior convenience sake, omit the negative sign and express the price elasticity oI
demand by positive number.

(2) Geometric Method/Point Elasticity Method:

"%he measurement oI elasticity at a point oI the demand curve is called point elasticity.

%he point elasticity oI demand method is used as a measure oI the change in the quantity demanded in
response to a very small changes in price. %he point elasticity oI demand is deIined as:

"%he proportionate change in the quantity demanded resulting Irom a very small proportionate change in
price".

Measurement of Geometric/Point Elasticity Method:

(i) Measurement of Elasticity on a Linear Demand Curve:

%he price elasticity oI demand can also be measured at any point on the demand curve. II the demand
curve is linear (straight line), it has a unitary elasticity at the mid point. %he total revenue is maximum at
this point.

Any point above the midpoint has an elasticity greater than 1, (E
d
~ 1). Here, price reduction leads to an
increase in the total revenue (expenditure). Below the midpoint elasticity is less than 1. (E
d
1). Price
reduction leads to reduction in the total revenue oI the Iirm.

Graph/Diagram:



%he formula applied Ior measuring the elasticity at any point on the straight line demand curve is:

E
d
Aq X p
Ap q
%he elasticity at each point on the demand curve can be traced with the help oI point method as:

E
d
Lower Segment Upper Segment

In the Iigure (6.9) AG is the linear demand curve (1). Elasticity oI demand at its mid point D is equal to
unity. At any point to the right oI D, the elasticity is less than unity (E
d
1) and to the leIt oI D, the
elasticity is greater than unity (E
d
~ 1).

(1) Elasticity oI demand at point D DG 400 1 (Unity).
DA 400

(2) Elasticity oI demand at point E GE 200 0.33 (1).
EA 600

(3) Elasticity oI Demand at point C GC 600 3 (~1).
CA 200

(4) Elasticity oI Demand at point C is inIinity.

(5) At point G, the elasticity oI demand is zero.

Summing up, the elasticity oI demand is diIIerent at each point along a linear demand curve. At high
prices, demand is elastic. At low prices, it is inelastic. At the midpoint, it is unit elastic.

(ii) Measurement of Elasticity on a Non Linear Demand Curve:

II the demand curve is non linear, then elasticity at a point can be measured by drawing a tangent at the
particular point. %his is explained with the help oI a Iigure given below:



In Iigure 6.10, the elasticity on DD
/
demand curve is measured at point C by drawing a tangent. At point
C:

E
d
B BC 400 2 (~1).
O CA 200

Here elasticity is greater than unity. Point C lies above the midpoint oI the demand curve DD
/
. In case the
demand curve is a rectangular hyperbola, the change in price will have no eIIect on the total amount spent
on the product. As such, the demand curve will have a unitary elasticity at all points.

(3) Arc Elasticity:

Normally the elasticity varies along the length oI the demand curve. II we are to measure elasticity
between any two points on the demand curve, then the rc Elasticity Method, is used. Arc elasticity is a
measure oI average elasticity between any two points on the demand curve. It is deIined as:

"%he average elasticity oI a range oI points on a demand curve".

Formula:

Arc elasticity is calculated by using the Iollowing Iormula:
-
E
d
Aq X P
1
+ P
2

Ap q
1
+ q
2


Here:

Aq denotes change in quantity.

Ap denotes change in price.

q
1
signiIies initial quantity.

q
2
denotes new quantity.



P
1
stands Ior initial price.

P
2
denotes new price.

Graphic Presentation of Measuring Elasticity Using the Arc Method:



In this Iig. (6.11), it is shown that at a price oI $10, the quantity oI demanded oI apples is 5 kg. per day.
When its price Ialls Irom $10 to $5, the quantity demanded increases to 12 Kgs oI apples per day. %he arc
elasticity oI AB part oI demand curve DD
/
can be calculated as under:

E
d
Aq X P
1
+ P
2

Ap q
1
+ q
2


E
d
7 X 10 + 5 7 X 15 7 X 15 21 1.23
5 5 + 12 5 17 5 17 17

%he arc elasticity is more than unity.

Types of Elasticity of Demand:

%he quantity oI a commodity demanded per unit oI time depends upon various Iactors such as the price oI
a commodity, the money income oI the prices oI related goods, the tastes oI the people, etc., etc.

Whenever there is a change in any oI the variables stated above, it brings about a change in the quantity
oI the commodity purchased over a speciIied period oI time. %he elasticity oI demand measures the
responsiveness oI quantity demanded to a change in any one oI the above Iactors by keeping other Iactors
constant. When the relative responsiveness or sensitiveness oI the quantity demanded is measured to
changes, in its price, the elasticity is said be price elasticity oI demand.

When the change in demand is the result oI the given change in income, it is named as income elasticity
oI demand. Sometimes, a change in the price oI one good causes a change in the demand Ior the other.
%he elasticity here is called cross electricity oI demand. %he three main types of elasticity of demand are
now discussed in brieI.

(1) Price Elasticity of Demand:
Definition and Explanation:
%he concept oI price elasticity oI demand is commonly used in economic literature. !rice elasticity of
demand is the degree oI responsiveness oI quantity demanded oI a good to a change in its price.
Precisely, it is deIined as:
"%he ratio oI proportionate change in the quantity demanded oI a good caused by a given proportionate
change in price".

Formula:
%he Iormula Ior measuring price elasticity oI demand is:
Price Elasticity of Demand Percentage in "uantity Demand
Percentage Change in Price

E
d
Aq X P
Ap "
Example:
Let us suppose that price oI a good Ialls Irom $10 per unit to $9 per unit in a day. %he decline in price
causes the quantity oI the good demanded to increase Irom 125 units to 150 units per day. %he price
elasticity using the simpliIied Iormula will be:

E
d
Aq X P
Ap "
Aq 150 - 125 25
Ap 10 - 9 1
Original Quantity 125
Original Price 10
E
d
25 / 1 x 10 / 125 2
%he elasticity coeIIicient is greater than one. %hereIore the demand Ior the good is elastic.

%ypes:

%he concept oI price elasticity oI demand can be used to divide the goods in to three groups.

(i) Elastic. When the percent change in quantity oI a good is greater than the percent change in its price,
the demand is said to be elastic. When elasticity oI demand is greater than one, a Iall in price increases the
total revenue (expenditure) and a rise in price lowers the total revenue (expenditure).

(ii) Unitary Elasticity. When the percentage change in the quantity oI a good demanded equals
percentage in its price, the price elasticity oI demand is said to have unitary elasticity. When elasticity oI
demand is equal to one or unitary, a rise or Iall in price leaves total revenue unchanged.

(iii) Inelastic. When the percent change in quantity oI a good demanded is less than the percentage
change in its price, the demand is called inelastic. When elasticity oI demand is inelastic or less than one,
a Iall in price decreases total revenue and a rise in its price increases total revenue.

(2) Income Elasticity of Demand:

Definition and Explanation:

Income is an important variable aIIecting the demand Ior a good. When there is a change in the level oI
income oI a consumer, there is a change in the quantity demanded oI a good, other Iactors remaining the
same. %he degree oI change or responsiveness oI quantity demanded oI a good to a change in the income
oI a consumer is called income elasticity oI demand. Income elasticity oI demand can be deIined as:

"%he ratio oI percentage change in the quantity oI a good purchased, per unit oI time to a percentage
change in the income oI a consumer".

Formula:

%he Iormula Ior measuring the income elasticity oI demand is the percentage change in demand Ior a
good divided by the percentage change in income. Putting this in symbol gives.

E
y
Percentage Change in Demand
Percentage Change in Income

SimpliIied Iormula: E
y
Aq X P
Ap "
Example:

A simple example will show how income elasticity oI demand can be calculated. Let us assume that the
income oI a person is $4000 per month and he purchases six CD's per month. Let us assume that the
monthly income oI the consumer increase to $6000 and the quantity demanded oI CD's per month rises to
eight. %he elasticity oI demand Ior CD's will be calculated as under:

Aq 8 - 6 2

Ap $6000 - $4000 $2000

Original quantity demanded 6

Original income $4000

E
y
Aq / Ap x P / " 2 / 200 x 4000 / 6 0.66

%he income elasticity is 0.66 which is less than one.

Types:

When the income oI a person increases, his demand Ior goods also changes depending upon whether the
good is a normal good or an inIerior good. For normal goods, the value oI elasticity is greater than zero
but less than one. Goods with an income elasticity oI less than 1 are called inIerior goods. For example,
people buy more Iood as their income rises but the increase in its demand is less than the increase in
income.

(3) Cross Elasticity of Demand:

Definition and Explanation:

%he concept oI cross elasticity of demand is used Ior measuring the responsiveness oI quantity demanded
oI a good to changes in the price oI related goods. Cross elasticity oI demand is deIined as:

"%he percentage change in the demand oI one good as a result oI the percentage change in the price oI
another good".

Formula:

%he Iormula Ior measuring, cross, elasticity oI demand is:

E
xy
Change in "uantity Demanded of Good X
Change in Price of Good Y

%he numerical value oI cross elasticity depends on whether the two goods in question are substitutes,
complements or unrelated.

Types and Example:

(i) Substitute Goods. When two goods are substitute oI each other, such as coke and Pepsi, an increase in
the price oI one good will lead to an increase in demand Ior the other good. %he numerical value oI goods
is positive.

For example there are two goods. Coke and Pepsi which are close substitutes. II there is increase in the
price oI Pepsi called good y by 10 and it increases the demand Ior Coke called good X by 5, the cross
elasticity oI demand would be:

E
xy
Aq
x
/ Ap
y
0.2

Since E
xy
is positive (E ~ 0), thereIore, Coke and Pepsi are close substitutes.

(ii) Complementary Goods. However, in case oI complementary goods such as car and petrol, cricket
bat and ball, a rise in the price oI one good say cricket bat by 7 will bring a Iall in the demand Ior the
balls (say by 6). %he cross elasticity oI demand which are complementary to each other is, thereIore,
6 / 7 0.85 (negative).

(iii) Unrelated Goods. %he two goods which a re unrelated to each other, say apples and pens, iI the price
oI apple rises in the market, it is unlikely to result in a change in quantity demanded oI pens. %he
elasticity is zero oI unrelated goods.

Factors Determining Price Elasticity of Demand:

%he price elasticity oI demand is not the same Ior all commodities. It may be or low depending upon
number oI Iactor. %hese factors which influence price elasticity of demand, in brieI, are as under:

(i) Nature of Commodities. In developing countries oI the world, the per capital income oI the people is
generally low. %hey spend a greater amount oI their income on the purchase oI necessaries oI liIe such as
wheat, milk, course cloth etc. %hey have to purchase these commodities whatever be their price. %he
demand Ior goods oI necessities is, thereIore, less elastic or inelastic. %he demand Ior luxury goods, on
the other hand is greatly elastic.

For example, iI the price oI burger Ialls, its demand in the cities will go up.

(ii) Availability of Substitutes. II a good has greater number oI close substitutes available in the market,
the demand Ior the good will be greatly elastic.

For examples, iI the price oI Coca Cola rises in the market, people will switch over to the consumption oI
Pepsi Cola, which is its close substitute. So the demand Ior Coca Cola is elastic.

(iii) Proportion of the Income Spent on the Good. II the proportion oI income spent on the purchase oI
a good is very small, the demand Ior such a good will be inelastic.

For example, iI the price oI a box oI matches or salt rises by 50, it will not aIIect the consumers demand
Ior these goods. %he demand Ior salt, maker box thereIore will be inelastic. On the other hand, iI the price
oI a car rises Irom $6 lakh to $9 lakh and it takes a greater portion oI the income oI the consumers, its
demand would Iall. %he demand Ior car is, thereIore, elastic.

(iv) Time. %he period oI time plays an important role in shaping the demand curve. In the short run, when
the consumption oI a good cannot be postponed, its demand will be less elastic. In the long run iI the rise
price persists, people will Iind out methods to reduce the consumption oI goods. So the demand Ior a
good in the, long run is elastic, other things remaining constant.

For example iI the price oI electricity goes up, it is very diIIicult to cut back its consumption in the short
run. However, iI the rise in price persists, people will plan substitution gas heater, Iluorescent bulbs etc.
so that they use less`electricity. So the electricity oI demand will be greater (E
d
~ 1) in the long run than
in the short run.

(5) Number of Uses of a Good. II a good can be put to a number oI uses, its demand is greater elastic (E
d

~ 1).

For example, iI the price oI coal Ialls, its quantity demanded will rise considerably because demand will
be coming Irom households, industries railways etc.

(6) Addition. II a product is habit Iorming say Ior example, cigarette, the rise in its price would not
induce much change in demand. %he demand Ior habit Iorming good is, thereIore, less elastic.

(7) 1oint Demand. II two goods are Jointly demand, then the elasticity oI demand depends upon the
elasticity oI demand oI the other Jointly demanded good.

For example, with the rise in price oI cars, its demand is slightly aIIected, then the demand Ior petrol will
also be less elastic.

Importance of Elasticity of Demand:

(1) Theoretical Importance:

%he concept oI elasticity oI demand is very useIul as it has got both theoretical and practical advantages.
As regards its importance in the academic interest, the concept, is very helpIul in the theory oI value. In
the words oI Keynes:

"%he concept oI elasticity is so important that in the provision oI terminology and apparatus to aid
thought, I do not think, arshall did any greater service than by the explicit introduction oI the idea oI the
elasticity".

(2) Practical Importance:

(i) Importance in taxation policy. As regards its practical advantages, the concept has immense
importance in the sphere oI government Iinance. When a Iinance minister levies a tax on a certain
commodity, he has to see whether the demand Ior that commodity is elastic or inelastic.

II the demand is inelastic, he can increase the tax and thus can collect larger revenue. But iI the demand oI
a commodity is elastic, he is not in a position to increase the rate oI a tax. II he does so, the demand Ior
that commodity will be, calculated and the total revenue reduced.

(ii) Price discrimination by monopolist. II the monopolist Iinds that the demand Ior his commodities is
inelastic, he will at once Iix the price at a higher level in order to maximize his net proIit. In case oI
elastic demand, he will lower the price in order to increase, his sale and derive the maximum net proIit.
%hus we Iind that the monopolists also get practical advantages Irom the concept oI elasticity.

(iii) Price discrimination in cases of joint supply. %he concept oI elasticity is oI great practical
advantage where the separate, costs oI Joint products cannot be measured. Here again the prices are Iixed
on the principle. "What the traIIic will bear" as is being done in the railway rates and Iares.

(iv) Importance to businessmen. %he concept oI elasticity is oI great importance to businessmen. When
the demand oI a good is elastic, they increases sale by towering its price. In case the demand' is inelastic,
they are then in a position to charge higher price Ior a commodity.

(v) Help to trade unions. %he trade unions can raise the wages oI the labor in an industry where the
demand oI the product is relatively inelastic. On the other hand, iI the demand, Ior product is relatively
elastic, the trade unions cannot press Ior higher wages.

(vi) Use in international trade. %he term oI trade between two countries are based on the elasticity oI
demand oI the traded goods.

(vii) Determination of rate of foreign exchange. %he rate oI Ioreign exchange is also considered on the
elasticity oI imports and exports oI a country.
.
(viii) Guideline to the producers. %he concept oI elasticity provides a guideline to the producers Ior the
amount to be spent on advertisement. II the demand Ior a commodity is elastic, the producers shall have
to spend large sums oI money on advertisements Ior increasing the sales.

(ix) Use in factor pricing. %he Iactors oI production which have inelastic demand can obtain a higher
price in the market then those which have elastic demand. %his concept explains the reason oI variation in
Iactor pricing.

Equilibrium of Demand and Supply:

Meaning and Definition:

%he price oI a commodity in the market is determined by the interaction oI the Iorces oI demand and
supply. By "demand for a commodity" at a given price is meant:

"%he total quantity oI that commodity which buyers will take at diIIerent prices per unit oI time".

While "supply of a commodity" at a given price reIers to:

"%hat quantity oI the commodity which sellers are willing to oIIer Ior sale at diIIerent prices per unit oI
time".

II we construct a list or table oI the diIIerent amounts oI the commodity which consumers purchase at
diIIerent prices in the market, we get the market demand schedule. Similarly, supply schedule is a list or a
table oI diIIerent amounts oI the commodity that are oIIered Ior sale in the market at diIIerent prices per
unit oI time.

In the market, there are large number oI buyers and sellers. It is the desire oI every buyer in the market to
purchase a commodity at the lowest possible price while the sellers wish to sell it at the highest possible
price.

When buyers compete among themselves Ior the purchase oI particular commodity, the price oI that
commodity goes up and when there is competition amongst the sellers, the price comes down.

Equilibrium Price:

%he price oI a commodity tends to settle at a point where the quantity demanded is exactly equal to the
quantity supplied. %he price at which the buyers and sellers are willing to buy and sell an equal amount oI
commodity, is called the, equilibrium price We illustrate the above proposition with the help oI a
schedule and a curve.

Schedule:

"uantity Supplied
(Cooking Oil Kg) Per
Week
Price (Dollars) "uantity Demanded (Cooking
Oil Kg) Per Week
800
600
500
450
19
18
17
16
100
250
400
450
350
100
15
14
500
700

II we study the above schedule careIully, we will Iind that when the price oI cooking oil is $16 per
kilogram, the total quantity demanded in a week is exactly equal to the total quantity supplied. So $16 is
the equilibrium price Ior the period and the equilibrium amount, i.e. the quantity demanded and oIIered
Ior sale is 450 kilograms oI cooking oil is:

Equation:
"
d
"
s
II the conditions assumed above remain the same, then there can be no equilibrium price other
than $16.

Example:
For instance, iI the price oI cooking oil happens to rise to$18 per kilogram. At this price, the sellers are
anxious to sell 600 kilograms oI ghee but the buyers are willing to, buy only 250 kilograms. %he sellers
will compete with one another to dispose oII this surplus stock. %he competition among the sellers will
result in lowering the price. When the price comes down to $16 (i.e., the equilibrium price), then the
whole oI the stock will be sold.

Conversely, iI the price happens to Iall to $14 per kilogram, the buyers would like to buy 700 kilograms
oI cooking oil, but the sellers are willing to sell only 100 kilograms. %he buyers, in order to buy more
cooking oil at a lower price will compete among themselves. %his competition among the buyers will
increase the price oI ghee. Finally, the price will be reestablished at the equilibrium price which is $16.

Diagram/Figure:

%he determination oI the equilibrium price can be proved graphically.



In the Iigure (8.1) DD
/
is the demand curve which, represents the diIIerent amount oI .the commodity that
are purchased in the market at diIIerent prices, SS
/
is the supply cure which indicate, the amount oI the
commodity that is oIIered Ior sale at diIIerent prices per unit oI time.

N is the equilibrium price i.e., $16 and ON 450 kg. is the equilibrium amounts. II the price is below
the equilibrium price ($16), there are upward pressure on price due to the resulting shortage oI good.
In case, the price is above the. equilibrium, there is a downward pressure on price caused by the resulting
surplus oI good. II is only at price N, the buyers take oI the market exactly what sellers place on the
market.

Effects of Changes in Demand on Equilibrium Market:

We know that iI the price rises, other things remaining the same, people buy less oI that commodity and iI
price Ialls, people buy more oI that commodity. Let us now discuss the effects of changes in demand on
equilibrium price.

A change to demand can take place independently oI change in price, i.e., price remaining the same,
people may purchase more or less oI the commodity. When larger quantity is demanded at the same old
price or the same old quantity is demanded at a higher price we say, the demand has risen. In such a case,
the whole oI demand curve rises above the original demand curve. In case oI a Iall in demand, the whole
oI the demand curve Ialls below the original demand curve.

In order to study the eIIect oI the changes in demand on equilibrium price, let us assume that no change
takes place in the supply schedule, i.e., it remains Iixed. II demand rises, more quantity will be purchased
at a higher price. On the other hand, iI demand Ialls, less commodity will be purchased at a lower price.
%his can also be illustrated in the Iollowing diagram.

Diagram/Figure:



In the Iigure (8.2) DD
/
is the original demand curve. P is the equilibrium price and O the equilibrium
amount. When demand rises, supply remaining the same, the equilibrium amount increases Irom O to
OG and the equilibrium price rises Irom P to FG. In case oI Iall oI in demand, which is indicated by
D
2
D
2
curve, the quantity demanded decreases Irom O to OK and the equilibrium price Ialls Irom P to
LK.
Now a question can be asked that when the demand rises, does it aIIect more on the price or on the
quantity oI the commodity to be sold? %he answer to this simple question, is that iI the supply is perIectly
elastic, a rise in demand will increase the quantity but will not aIIect the price. II the supply is perIectly
inelastic, then a rise in demand will aIIect the price but not the quantity. %his can be shown with the help
oI the diagram. In case oI perIect elastic supply, (Fig. 8.3) when demand rises, the supply increases Irom
OK to OI with Iurther rise in demand D
2
D
2
the supply increases Irom OI to ON.



Supply Perfectly Inelastic:



In Iig. 8.4, the supply is perIectly inelastic. A rise in demand aIIects the price which rises Irom R to K
and with the Iurther rise in demand to L. %he quantity supplied remains the same O.

In the the world in which we live, the supply is seldom perIectly elastic or perIectly inelastic. It is either
equal to unity or greater than unity, or less than unity. We will, thereIore, examine these, cases now. II
elasticity oI supply is to unity and demand rises, the price and quantity will change in equal proportion.

(i) Elasticity of Supply is Equal to Unity:

%he quantity and price change in equal proportion with a rise in demand as is clear in Iig. 8.5.



(ii) Elasticity of Supply Greater Than Unity:

II the elasticity oI supply is greater than unity, a rise in demand will aIIect the supply which will change
in greater proportion than the price as is obvious Irom the Iollowing Iig. 8.6.



In Iig. (8.6) when demand rises, KL quantity supplied is greater in proportion than PN price.

(iii) Elasticity of Supply Less Than Unity:

II the elasticity oI supply is less than unity, a rise in demand will change the price in greater proportion
than the quantity as shown in Iig. 8.7.

In Iig. 8.7 the proportionate change in quantity demanded KL is less than the change in price RN.
Production Function:

Definition:

A given output can be produced with many diIIerent combinations oI Iactors oI production (land, labor,
capita! and organization) or inputs. %he output, thus, is a Iunction oI inputs. %he Iunctional relationship
that exists between physical inputs and physical output oI a Iirm is called production function.

Formula:

In abstract term, it is written in the Iorm oI Iormula:

" f (x
1
, x
2
, ......., x
n
)

Q is the maximum quantity oI output and x
1
, x
2
, x
n
are quantities oI various inputs. %he Iunctional
relationship between inputs and output is governed by the laws oI returns.

%he laws oI returns are categorized into two types.

(i) %he law oI variable proportion seeking to analyze production in the short period.

(ii) %he law oI returns to scale seeking to analyze production in the long period.

Law of Variable Proportions/Law of Non Proportional Returns/Law of Diminishing Returns:
(Short Run Analysis of Production):

Definition:

%here were three laws oI returns mentioned in the history oI economic thought up till AlIred arshall's
time. %hese laws were the laws oI increasing returns, diminishing returns and constant returns. Dr.
arshall was oI the view that the law oI diminishing returns applies to agriculture and the law oI
increasing returns to industry. uch time was wasted in discussion oI this issue. However, it was later on
recognized that there are not three laws oI production. It is only one law oI production which has three
phases, increasing, diminishing and negative production. %his general law oI production was named as
the aw of Jariable !roportions or the aw of Aon-!roportional Returns.

%he Law oI Variable Proportions which is the new name oI the Iamous law of Diminishing Returns has
been deIined by Stigler in the Iollowing words:

"As equal increments oI one input are added, the inputs oI other productive services being held constant,
beyond a certain point, the resulting increments oI produce will decrease i.e., the marginal product will
diminish".

According to Samuelson:
"An increase in some inputs relative to other Iixed inputs will in a given state oI technology cause output
to increase, but aIter a point, the extra output resulting Irom the same addition oI extra inputs will become
less".

Assumptions:

%he law oI variable proportions also called the law oI diminishing returns holds good under the Iollowing
assumptions:

(i) Short run. %he law assumes short run situation. %he time is too short Ior a Iirm to change the quantity
oI Iixed Iactors. All the, resources apart Irom this one variable, are held unchanged in quantity and
quality.
(ii) Constant technology. %he law assumes that the technique oI production remains unchanged during
production.
(iii) Homogeneous factors. Each Iactor unit in assumed to he identical in amount and quality.

Explanation and Example:
%he law oI variable proportions is, now explained with the help oI table and graph.
Schedule:

Fixed Inputs
(Land Capital)
Variable
Resource
(labor)
Total Produce (TP
"uintals)
Marginal Product
(MP "uintals)
Average
Product (AP
"uintals)
30
30
1
2
10
25
10
15
Increasing
marginal return
10
12.5

30
30
30
30
30
3
4
5
6
7
37
47
55
60
63
12
10
8
5
3
Diminishing
marginal returns
12.3
11.8
11.0
10.0
9.0

30
30
8
9
63
62
0
-1
Negative marginal
returns
7.9
6.8

In the table above, it is assumed that a Iarmer has only 30 acres oI land Ior cultivation. %he investment on
it in the Iorm oI tubewells, machinery etc., (capital) is also Iixed. %hus land and capital with the Iarmer is
Iixed and labor is the variable resource.

As the Iarmer increases units oI labor Irom one to two to the amount oI other Iixed resources (land and
capital), the marginal as well as average product increases. %he total product also increase at an increasing
rate Irom 10 to 25 quintals. It is the stage oI increasing returns.

%he stage oI increasing returns with the employment oI more labor does not last long. It is shown in the
table that with the employment oI 3rd labor at the Iarm, the marginal product and the average product
(AP) both Iall but marginal product (P) Ialls more speedily than the average product AP). %he Iall in
P and AP continues as more men are put on the Iarm.

%he decrease, however, remains positive up to the 7th labor employed. On the employment oI 7th worker,
the total production remains constant at 63 quintals. %he marginal product is zero. iI more men are
employed the marginal product becomes negative. It is the stage oI negative returns. We here Iind the
behavior oI marginal product (P). it shows three stages. In the Iirst stage, it increases, in the 2nd it
continues to Iall and in the 3rd stage it becomes negative.

Three Stages of the Law:

%here are three phases or stages oI production, as determined by the law oI variable proportions:

(i) Increasing returns.
(ii) Diminishing returns.
(iii) Negative returns.

Diagram/Graph: These stages can be explained with the help of graph below:



(i) Stage of Increasing Returns. %he Iirst stage oI the law oI variable proportions is generally called the
stage oI increasing returns. In this stage as a variable resource (labor) is added to Iixed inputs oI other
resources, the total product increases up to a point at an increasing rate as is shown in Iigure 11.1.

%he total product Irom the origin to the point K on the slope oI the total product curve increases at an
increasing rate. From point K onward, during the stage II, the total product no doubt goes on rising but its
slope is declining. %his means that Irom point K onward, the total product increases at a diminishing rate.
In the Iirst stage, marginal product curve oI a variable Iactor rises in a part and then Ialls. %he average
product curve rises throughout .and remains below the P curve.

Causes of Initial Increasing Returns:

%he phase oI increasing returns starts when the quantity oI a Iixed Iactor is abundant relative to the
quantity oI the variable Iactor. As more and more units oI the variable Iactor are added to the constant
quantity oI the Iixed Iactor, it is more intensively and eIIectively used. %his causes the production to
increase at a rapid rate. Another reason oI increasing returns is that the Iixed Iactor initially taken is
indivisible. As more units oI the variable Iactor are employed to work on it, output increases greatly due
to Iuller and eIIective utilization oI the variable Iactor.

(ii) Stage of Diminishing Returns. %his is the most important stage in the production Iunction. In stage
2, the total production continues to increase at a diminishing rate until it reaches its maximum point (H)
where the 2nd stage ends. In this stage both the
marginal product (P) and average product oI the variable Iactor are diminishing but are positive.

Causes of Diminishing Returns:

%he 2nd phase oI the law occurs when the Iixed Iactor becomes inadequate relative to the quantity oI the
variable Iactor. As more and more units oI a variable Iactor are employed, the marginal and average
product decline. Another reason oI diminishing returns in the production Iunction is that the Iixed
indivisible Iactor is being worked too hard. It is being used in non-optima! proportion with the variable
Iactor, rs. J. Robinson still goes deeper and says that the diminishing returns occur because the Iactors
oI production are imperIect substitutes oI one another.

(iii) Stage of Negative Returns. In the 3rd stage, the total production declines. %he %P, curve slopes
downward (From point H onward). %he P curve Ialls to zero at point L
2
and then is negative. It goes
below the X axis with the increase in the use oI variable Iactor (labor).

Causes of Negative Returns:

%he 3rd phases oI the law starts when the number oI a variable, Iactor becomes, too excessive relative, to
the Iixed Iactors, A producer cannot operate in this stage because total production declines with the
employment oI additional labor.

A rational producer will always seek to produce in stage 2 where P and AP oI the variable Iactor are
diminishing. At which particular point, the producer will decide to produce depends upon the price oI the
Iactor he has to pay. %he producer will employ the variable Iactor (say labor) up to the point where the
marginal product oI the labor equals the given wage rate in the labor market.

Importance:

%he law oI variable proportions has vast general applicability. BrieIly:

(i) It is helpIul in understanding clearly the process oI production. It explains the input output relations.
We can Iind out by-how much the total product will increase as a result oI an increase in the inputs.
(ii) %he law tells us that the tendency oI diminishing returns is Iound in all sectors oI the economy which
may be agriculture or industry.
(iii) %he law tells us that any increase in the units oI variable Iactor will lead to increase in the total
product at a diminishing rate. %he elasticity oI the substitution oI the variable Iactor Ior the Iixed Iactor is
not inIinite.

From the law oI variable proportions, it may not be understood that there is no hope Ior raising the
standard oI living oI mankind. %he Iact, however, is that we can suspend the operation oI diminishing
returns by continually improving the technique oI production through the progress in science and
technology.

Law of Diminishing Returns/Law of Increasing Cost:
(Version of Classical and Neo Classical Economists):

Definition:

%he law of diminishing returns (also called the aw of ncreasing Costs) is an important law oI micro
economics. %he law oI diminishing returns states that: "II an increasing amounts oI a variable Iactor are
applied to a Iixed quantity oI other Iactors per unit oI time, the increments in total output will Iirst
increase but beyond some point, it begins to decline".

Richard A. Bilas describes the law oI diminishing returns in the Iollowing words: "II the input oI one
resource to other resources are held constant, total product (output) will increase but beyond some point,
the resulting output increases will become smaller and smaller".

%he law oI diminishing return can be studied Irom two points oI view, (i) as it applies to agriculture and
(ii) as it applies in the Iield oI industry.

(1) Operation of Law of Diminishing Returns in Agriculture:

Traditional Point of View. %he classical economists were oI the opinion that the taw oI diminishing
returns applies only to agriculture and to some extractive industries, such as mining, Iisheries urban land,
etc. %he law was Iirst stated by a Scottish Iarmer as such. It is the practical experience oI every Iarmer
that iI he wishes to raise a large quantity oI Iood or other raw material requirements oI the world Irom a
particular piece oI land, he cannot do so. He knows it Iully that the producing capacity oI the soil is
limited and is subject to exhaustation.

As he applies more and more units oI labor to a given piece oI land, the total produce no doubt increases
but it increases at a diminishing rate.

For example, iI the number oI labor is doubled, the total yield oI his land will not be double. It will be
less than double. II it becomes possible to increase the. yield in the very same ratio in which the units oI
labor are increased, then the raw material requirements oI the whole world can be met by intensive
cultivation in a single Ilower-pot. As this is not possible, so a rational Iarmer increases the application oI
the units oI labor on a piece oI land up to a point which is most proIitable to him. %his is in brieI, is the
law oI diminishing returns. Marshall has stated this law as such:

"As Increase in capital and labor applied to the cultivation oI land causes in general a less than
proportionate increase in the amount oI the produce raised, unless it happens to coincide with the
improvement in the act oI agriculture".

Explanation and Example:
%his law can be made more clear iI we explain it with the help, oI a schedule and a curve.

Schedule:

Fixed Input Inputs of Variable
Resources
Total Produce TP
(in tons)
Marginal
product MP
(in tons)
12 Acres
12 Acres
12 Acers
12 Acres
12 Acers
12 Acres
1 Labor
2 Labor
3 Labor
4 Labor
5 Labor
6 Labor
50
120
180
200
200
195
50
70
60
20
0
-5

In the schedule given above, a Iirm Iirst cultivates 12 acres oI land (Fixed input) by applying one unit oI
labor and produces 50 tons oI wheat.. When it applies 2 units oI labor, the total produce increases to 120
tons oI wheat, here, the total output increased to more than double by doubling the units oI labor. It is
because the piece oI land is under-cultivated. Had he applied two units oI labor in the very beginning, the
marginal return would have diminished by the application oI second unit oI labor.

In our schedules the rate oI return is at its maximum when two units oI labor are applied. When a third
unit oI labor is employed, the marginal return comes down to 60 tons oI wheat With the application oI 4
th

unit. the marginal return goes down to 20 tons oI wheat and when 5
th
unit is applied it makes no addition
to the total output. %he sixth unit decreased it. %his tendency oI marginal returns to diminish as successive
units oI a variable resource (labor) are added to a Iixed resource (land), is called the law oI diminishing
returns. %he above schedule can be represented graphically as Iollows:

Diagram/Graph:



In Fig. (11.2) along OX are measured doses oI labor applied to a piece oI land and along OY, the
marginal return. In the beginning the land was not adequately cultivated, so the additional product oI the
second unit increased more than oI Iirst. When 2 units oI labor were applied, the total yield was the
highest and so was the marginal return. When the number oI workers is increased Irom 2 to 3 and more.
the P begins to decrease. As IiIth unit oI labor was applied, the marginal return Iell down to zero and
then it decreased to 5 tons.

Assumptions:

%he table and the diagram is based on the Iollowing assumptions:

(i) %he time is too short Ior a Iirm to change the quantity oI Iixed Iactors.

(ii) It is assumed that labor is the only variable Iactor. As output increases, there occurs no change in the
Iactor prices.

(iii) All the units oI the variable Iactor are equally eIIicient.

(iv) %here are no changes in the techniques oI production.

(2) Operation of the Law in the Field of Industry:

%he modern economists are oI the opinion that the law oI diminishing returns is not exclusively conIined
to agricultural sector, but it has a much wider application. %hey are oI the view that whenever the supply
oI any essential Iactor oI production cannot be increased or substituted proportionately with the other
sectors, the return per unit oI variable Iactor begins to decline. %he law oI diminishing returns is thereIore,
also called the Law of Variable Proportions.

In agriculture, the law oI diminishing returns sets in at an early stage because one very important Iactor,
i.e., land is a constant Iactor there and it cannot be increased in right proportion with other variable
Iactors, i.e., labor and capital. In industries, the various Iactors oI production can be co-operated, up to a
certain point. So the additional return per unit oI labor and capital applied goes on increasing till there
takes place a dearth oI necessary agents oI production. From this, we conclude that the law oI diminishing
return arises Irom disproportionate or deIective combination oI the various agents oI production. Or we
can any that when increasing amounts oI a variable Iactor are applied to Iixed quantities oI other Iactors,
the output per unit oI the variable Iactor eventually decreases.

Mrs. 1ohn Robinson goes deeper into the causes oI diminishing returns and says that:

"II all Iactors oI production become perIect substitute Ior one another, then the law oI diminishing returns
will not operate at any stage".

For instance, iI sugarcane runs short oI demand and some other raw material takes its place as its perIect
substitute, then the elasticity oI substitution between sugarcane and the other raw material will be inIinite.
%he price oI sugarcane will not rise and so the law oI diminishing returns will not operate.

%he law oI diminishing returns, thereIore, in due to ImperIect substitutability oI Iactors oI production.

%he law oI diminishing returns is also called as the aw of ncreasing Cost. %his is because oI the Iact
that as one applies successive units oI a variable Iactor to Iixed Iactor, the marginal returns begin to
diminish. With the cost oI each variable Iactor remaining unchanged by assumptions and the marginal
returns registering .decline, the cost per unit in general goes on increasing. %his tendency oI the cost per
unit to rise as successive units oI a variable Iactor are added to a given quantity oI a Iixed Iactor is called
the law oI Increasing Cost.

Importance:

%he law oI diminishing returns occupies an important place in economic theory. %he British classical
economists particularly althus, and Ricardo propounded various economic theories, on its basis.
althus, the pessimist economist, has based his Iamous theory oI Population on this law.

%he Ricardian theory oI rent is also based on the law oI diminishing retur

Law of Increasing Returns/Law of Diminishing Cost:
(Version of Classical and Neo Classical Economists):
DeIinition and Explanation:

%he law of increasing returns is also called the law of diminishing costs. %he law oI increasing return
states that:

"When more and more units oI a variable Iactor is employed, while other Iactor remain Iixed, there is an
increase oI production at a higher rate. %he tendency oI the marginal return to rise per unit oI variable
Iactors employed in Iixed amounts oI other Iactors by a Iirm is called the law oI increasing return".

An increase oI variable Iactor, holding constant the quantity oI other Iactors, leads generally to improved
organization. %he output increases at a rate higher than the rate oI increase in the employment oI variable
Iactor.

%he increase in output Iaster than inputs continues so long as there is not deIiciency oI an essential Iactor
in the process oI production. As soon as there occurs shortage or a wrong or deIective combination in
productive process, the marginal product begins to decline. %he law oI diminishing return begins to
operate. We can, thereIore, say that there are no separate laws applicable to agriculture and to industries.
It is only the law oI variable proportions which applies to a!! the diIIerent industries. However, the
duration oI stages in each productive undertaking will vary. %hey will depend upon the availability oI
resources, their combination in right proportions, etc., etc.

Application of the Law of Increasing Returns in Industries:

%here are certain manuIacturing industries where the Iactors oI production can be combined and
substituted up to a certain limit, it is the law oI increasing returns which operates. In the words oI Prof.
Chapman:

"%he expansion oI an industry in which there is no dearth oI necessary agents oI production tends to be
accompanied, other things being equal, by increasing returns".

%he increasing returns mainly arises Irom the Iact that large scale production is able to secure certain
economies oI production, both internal and external. When an industry is expanded, it reaps advantages oI
division oI labor, specialized machinery, commercial advantages, buying and selling wholesale,
economies in overhead expenses, utilization oI by products, use oI extensive publicity and advertisement,
availability oI cheap credit, etc.. etc.

%he law oI increasing returns also operates so long as a Iactor consists oI large indivisible units and the
plant is producing below its capacity. In that case, every additional investment will result in the increase
oI marginal productivity and so in lowering the cost oI production oI the commodity produced. %he
increase in the marginal productivity continues till the plant begins to produce to its Iull capacity.

Assumptions:

%he law rests upon the Iollowing assumptions:

(i) %here is a scope in the improvement oI technique oI production.
(ii) At least one Iactor oI production is assumed to be indivisible.
(iii) Some Iactors are supposed to be divisible.

Example:

%he law oI increasing returns can also be explained with the help oI a schedule and a curve.

Schedule:

Inputs Total Returns (meters of cloth) Marginal Returns
(meters of cloth)
1 100 100
2 250 150
3 450 200
4 750 300
5 1200 450
6 1850 650
7 2455 605
8 3045 600

In the above table it is dear that as the manuIacturer goes on expanding his business by investing
successive units oI inputs, the marginal return goes on increasing up to the 6th unit and then it beings to
decline steadily, Here, a question ca be asked as to why the law oI diminishing returns has operated in an
industry?

%he answer is very simple. %he marginal returns has diminished aIter the sixth unit because oI the non-
availability oI a Iactor or Iactors oI production or. the size oI the business has become so large that it has
become unwieldy to manage it, or the plant is producing to its Iull capacity and it is not possible Iurther to
reap the economies oI large scale production, etc., etc.

Diagram/Graph:



In Iigure 11.3, along OX axis are measured the units oI inputs applied and along OY axis the marginal
return is represented. PF is the curve representing the law oI increasing returns.

Compatibility of Diminishing and Increasing Returns:

It is oIten pointed out by the classical economists that the law oI diminishing returns is exclusively
conIined to agriculture and other extractive industries, such as mining Iisheries, etc. while manuIacturing
industries obey the law oI increasing returns. In the words oI Marshall:
"While the part which Nature plays in production shows a tendency to diminishing returns and the part
which man plays shows a tendency to increasing returns".

%he modern economists diIIer with this view and are oI the opinion that the law oI diminishing returns
applies both to agriculture and the industry. %he only diIIerence is that in agriculture the law oI
diminishing returns begins to operate at an early stage and in an industry somewhere at a later stage.

%he law oI increasing returns is also named as the Law oI Diminishing Cost. When the addition to output
becomes larger, as the Iirm adds successive units oI a variable input to some Iixed inputs, the per unit cost
begins to decline. %he tendency oI the cost per unit to decline with increased application oI a variable
Iactor to Iixed Iactors is called the Law oI Diminishing Cost.

Law of Constant Returns/Law of Constant Cost:
(Version of Classical and Neo Classical Economists):
DeIinition and Explanation:

%he law of constant returns also called law of constant cost. It is said to operate when with the addition
oI successive units oI one Iactor to Iixed amount oI other Iactors, there arises a proportionate increase in
total output. %he yield oI equal return on the successive doses oI inputs may occur Ior a very short period
in the process oI production. %he law oI constant return may prevail in those industries which represent a
combination oI manuIacturing as well as extractive industries.

On the side oI manuIacturing industries, every increased investment oI labor and capital may result in a
more than proportionate increase in the total output. While on the other extractive side, an increase in
investment may cause, in general, a less than proportionate increase in the amount oI produce raised. II
the tendency oI the marginal return to increase is just balanced by the tendency oI the marginal return to
diminish yielding an equal return, we have the operation oI the law oI constant returns. In the words oI
Marshall:

"II the actions oI the law oI increasing and diminishing returns are balanced, we have the law oI constant
return".
In actual liIe, the law oI constant returns can operate only iI the Iollowing conditions are IulIilled:

(i) %here should not be any increase in the prices oI raw materials in the industry. %his can only be
possible iI commodities are available in large supply.
(ii) %he prices oI various Iactors oI production should remain the same. %he .supply oI various Iactors oI
production needed Ior a particular industry should be perIectly elastic.
(iii) %he productive services should not be Iixed and indivisible.

II we study the above mentioned conditions careIully, we will easily conclude that in the actual world, it
is not possible to Iind an industry which obeys the law oI constant returns. %he law oI constant returns
can operate Ior a very short period when the marginal return moves towards the optimum point and
begins to decline. II the marginal return, at the optimum level remains the same with the increased
application oI inputs Ior a short while, then we have the operation oI law oI constant returns. %he law is
represented now in the Iorm oI a table and a curve.
Schedule:

Productive doses Total Return
(meters of cloth)
Marginal
Return (meters of
cloth)
1 60 60
2 120 60
3 180 60
4 240 60
5 300 60

In the table given above, the marginal return remains the same, i.e. 60 meters oI cloth with the increased
investment oI inputs.
Diagram/Graph:



In Iigure (11.4) along OX are measured the productive resources and along OY is represented the
marginal return. CR is the Iine representing the law oI constant returns. It is parallel to the base axis.
Law of Costs:
DeIinition and Explanation:

aw of Costs is also known as laws oI returns. As an industry is expanded with the increased investment
oI resources, the marginal cost (i.e., the amount which is added to the total cost when the output is
increased by one unit) decreases in some cases, increases in others and in some, it remains the same. %his
tendency on the part oI the marginal cost to Iall, rise or to remain the same as output is expanded, is
described in economics as the law of diminishing costs, the law of increasing costs, and the law of
constant costs.

II we know the money cost oI a unit oI a Iactor invested in a particular industry, then the marginal cost
can be derived easily dividing the money cost oI a unit oI Iactor by its marginal return.

%he Iollowing table will make clear as to how the marginal cost decreases with the increases in marginal
returns, rises with the Iall in marginal returns and remains constant with the marginal return remaining the
same. Let us suppose that the cost oI each unit oI Iactor applied is worth $100 only.

Schedule:

Units of
Factor
Total Return
(meters of Cloth)
Marginal Return
(meters)
Marginal Cost (in
Dollars) (per meter)
1 10 10 10
2 30 20 5
3 55 25 4
4 88 33 3
5 138 50 2
6 238 100 1
7 338 100 1
8 400 62 1
9 450 50 2
10 475 25 4
11 490 15 6

In the schedule given above, the taw oI diminishing costs operates up to the 6th unit, between the 6th and
7th units, it is the law oI constant costs which prevails and Irom 7th unit onward, it is the law oI
increasing costs which sets in.
Diagram/Graph:



In the Fig. (11.5) units oI Iactors are measured along OX axis and marginal cost along OY axis. %he
Iailing curve N represents the operation oI law oI diminishing costs. NP shows constant costs, and PC
indicates the increasing cost. C is the marginal cost curve.

Law of Returns to Scale:
DeIinition and Explanation:

%he law oI returns are oIten conIused with the law of returns to scale. %he law oI returns operates in the
short period. It explains the production behavior oI the Iirm with one Iactor variable while other Iactors
are kept constant. Whereas the law oI returns to scale operates in the long period. It explains the
production behavior oI the Iirm with all variable Iactors.

%here is no Iixed Iactor oI production in the long run. %he law oI returns to scale describes the
relationship between variable inputs and output when all the inputs, or Iactors are increased in the same
proportion. %he law oI returns to scale analysis the eIIects oI scale on the level oI output. Here we Iind
out in what proportions the output changes when there is proportionate change in the quantities oI all
inputs. %he answer to this question helps a Iirm to determine its scale or size in the long run.

It has been observed that when there is a proportionate change in the amounts oI inputs, the behavior oI
output varies. %he output may increase by a great proportion, by in the same proportion or in a smaller
proportion to its inputs. %his behavior oI output with the increase in scale oI operation is termed as
increasing returns to scale, constant returns to scale and diminishing returns to scale. %hese three laws oI
returns to scale are now explained, in brieI, under separate heads.

(1) Increasing Returns to Scale:
II the output oI a Iirm increases more than in proportion to an equal percentage increase in all inputs, the
production is said to exhibit increasing returns to scale.

For example, iI the amount oI inputs are doubled and the output increases by more than double, it is said
to be an increasing returns returns to scale. When there is an increase in the scale oI production, it leads to
lower average cost per unit produced as the Iirm enjoys economies oI scale.

(2) Constant Returns to Scale:

When all inputs are increased by a certain percentage, the output increases by the same percentage, the
production Iunction is said to exhibit constant returns to scale.

For example, iI a Iirm doubles inputs, it doubles output. In case, it triples output. %he constant scale oI
production has no eIIect on average cost per unit produced.

(3) Diminishing Returns to Scale:

%he term 'diminishing' returns to scale reIers to scale where output increases in a smaller proportion than
the increase in all inputs.

For example, iI a Iirm increases inputs by 100 but the output decreases by less than 100, the Iirm is
said to exhibit decreasing returns to scale. In case oI decreasing returns to scale, the Iirm Iaces
diseconomies oI scale. %he Iirm's scale oI production leads to higher average cost per unit produced.

Graph/Diagram:

%he three laws oI returns to scale are now explained with the help oI a graph below:



%he Iigure 11.6 shows that when a Iirm uses one unit oI labor and one unit oI capital, point a, it produces
1 unit oI quantity as is shown on the q 1 isoquant. When the Iirm doubles its outputs by using 2 units oI
labor and 2 units oI capital, it produces more than double Irom q 1 to q 3.

So the production Iunction has increasing returns to scale in this range. Another output Irom quantity 3 to
quantity 6. At the last doubling point c to point d, the production Iunction has decreasing returns to scale.
%he doubling oI output Irom 4 units oI input, causes output to increase Irom 6 to 8 units increases oI two
units only.

What is Production Function?
Definition and Explanation:
Production oI goods requires resources or inputs. %hese inputs are called factors of production named as
land, labor, capital and organization. A rational producer is always interested that he should get the
maximum output Irom the set oI resources or inputs available to him. He would like to combine these
inputs in a technical eIIicient manner so that he obtains maximum desired output oI goods. %he
relationship between the inputs and the resulting output is described as production function.

A production Iunction shows the relationship between the amounts oI Iactors used and the amount oI
output generated per period oI time.

Formula:
It can be expressed in algebraic Iorm as under:

X f (a
1
, a
2
,........, a
n
)

%his equation tells us the quantity oI the product X which can be produced by the given quantities oI
inputs (lands labor, capital) that are used in the process oI production. Here it may be noted that
production Iunction shows only the maximum amount oI output which can be produced Irom given
inputs. It is because production Iunction includes only eIIicient production process.

%he analysis oI production Iunction is generally carried with reIerence to time period which is called short
period and long period. In the short run, production Iunction is explained with one variable Iactor and
other Iactors oI productions are held constant. We have called this production Iunction as the Law of
Variable Proportions or the Law of Diminishing returns.

In the long run, production Iunction is explained by assuming all the Iactors oI production as variable.
%here are no Iixed inputs in the long run. Here the production Iunction is called the Law of Returns
according to the scale oI production.

As it is diIIicult to handle more than two variables in graph, we thereIore, explain the Law oI Returns
according to scale oI production by assuming only two inputs i.e., capital and labor and study how output
responds to their use.
Short Period Analysis of Production or Law of Variable Proportion:

%he short run is a period oI time in which only one input (say labor) is allowed to vary while other inputs
land and capital are held Iixed. In the short run, thereIore, production can be increased with one variable
Iactor and other Iactors remaining constant. In the short run, the law oI variable proportion governs the
production behavior oI a Iirm.

%he law oI variable proportion shows the direction and rate oI change in the output oI Iirm when the
amount oI only one Iactor oI production is varied while other Iactor oI production are held constant.

%he law oI variable proportion passes mainly through two phases:
(i) Increasing returns.
(ii) Diminishing returns.

%echnical EIIicient Combination:

Production Iunction establishes a physical relationship between output and inputs. It describes what is
technical Ieasible when the Iirm uses each combination oI input. %he Iirm can obtain a given level oI
output by using more labor and less capital or more capital and less labor. Production Iunction describes
the maximum output Ieasible Ior a given set oI inputs in technical eIIicient manner.

Production Function takes "uantities of Inputs:

It is imperative to note that production Iunction does not take unto account the prices oI input or oI the
output. It simply takes into account the quantities oI inputs which are employed to produce certain
quantities oI output.

Long Run Production With Variable Inputs:

%he long run is the lengthy period oI time during with all inputs can be varied. %here are no Iixed output
in the long run. All Iactors oI production are variable inputs.

We now analyze production Iunction by allowing two Iactors say labor and capital to very while all others
are held constant. With both Iactors are variable, a Iirm can produce a given level oI output by using more
labor and less capital or a greater amount oI capital and less labor or moderate amounts oI both. A Iirm
continues to substitute one input Ior another while continuing to produce the same level oI output.

II two inputs say labor and capital are allowed to vary, the resulting production Iunction can be illustrated
in the Iigure 12(a).

Diagram/Figure:



In this Iigure each curve (called an isoquant) represents a diIIerent level oI output. %he curves which lie
higher and to the right represent greater output levels than curves which are lower and to the leIt.

For example, point D represents a higher output level oI 250 units than point A or B which shows output
level oI 150 units.

%he curve isoquant which represents 150 units oI output illustrate that the same level oI output (150 units)
can be produced with diIIerent combinations oI labor and capital. Combination oI labor and capital
represented by A, can employ OL
1
quantity oI labor and OC
1
units oI capital to produce 150 units oI
output.

%he combination oI labor and capital represented by point B will use only OL
2
units oI labor and OC
1
oI
capital to produce the same level oI output. %hus, iI a country has surplus labor and less capital, it may
use the combination oI labor and capital represented by point A. In case the country has abundant capital
and less labor, it might produce at point B. %he isoquants through points A and B shows all the diIIerent
combinations oI labor and capita that can be used to produce 150 units oI output.

Isoquants:

Definition and Meaning:
%he word iso is oI Greek origin and means equal or same and quant means quantity. An isoquant may
be deIined as: "A curve showing all the various combinations of two factors that can produce a
given level of output. The isoquant shows the whole range of alternative ways of producing the
same level of output".

%he modern economists are using isoquant, or "ISO" product curves Ior determining the optimum Iactor
combination to produce certain units oI a commodity at the least cost.

Schedule:
%he concept oI isoquant or equal product curve can be better explained with the help oI schedule given
below:

Combinations Factor X Factor Y Total Output
A 1 14 100 E%ERS
B 2 10 100 E%ERS
C 3 7 100 E%ERS
D 4 5 100 E%ERS
E 5 4 100 E%ERS

In the table given above, it is shown that a producer employs two Iactors oI production X and Y Ior
producing an output oI 100 meters oI cloth. %here are Iive combinations which produce the same level oI
output (100 meters oI cloth).

%he Iactor combination A using 1 unit oI Iactor X and 14 units oI Iactor Y produces 100 meters oI cloth.
%he combination B using 2 units oI Iactor X and 10 units oI Iactor Y produces 100 meters oI cloth.
Similarly combinations C, U and E, employing 3 units oI X and 7 units oI Y, 4 units oI X and 5 units oI
Y, 5 units oI X and 4 units oI Y produce 100 units oI output, each. %he producer, here., is indiIIerent as to
which combination oI inputs he uses Ior producing the same amount oI output.

Diagram/Graph:

%he alternative techniques Ior producing a given level oI output can be plotted on a graph.



%he Iigure 12.1 shows y the 100 units isoquant plotted to ISO product schedule. %he Iive Iactor
combinations oI X and Y are plotted and are shown by points a, b, c, d and e. iI we join these points, it
Iorms an 'isoquant'.

An isoquant thereIore, is the graphic representation oI an iso-product schedule. It may here be noted that
all the Iactor combinations oI X and Y on an iso-product curve are technically eIIicient combinations. %he
producer is indiIIerent as to which combination he uses Ior producing the same level oI output. It is in this
way that an iso product curve is also called 'production indiIIerence curve'. In the Iigure 12.1, ISO
product IP curve represents the various combinations oI the two inputs which produce the same level oI
output (100 meters oI cloth).

Isoquant Map:

An isoquant map shows a set oI iso-product curves. Each isoquant represents a diIIerent level oI output.
A higher isoquant shows a higher level oI output and a lower isoquant represents a lower level oI output.

Diagram/Graph:



In the Iigure 12.2, a Iamily oI three iso-product curves which produce various level oI output is shown.
%he iso product IQ
1
yields 100 units oI output by using quantities oI inputs X and Y. So is also the case
with isoquant IQ
3
yielding 300 units oI output.

We conclude that an isoquant map includes a series, oI iso-product curves. Each isoquant represents a
diIIerent level oI output. %he higher the isoquant output, the Iurther right will be the isoquant.
Properties of Isoquants:
%he main properties of the isoquants are similar to those oI indiIIerence curves. %hese properties are
now discussed in brieI:

(i) An Isoquant Slopes Downward from Left to Right:

%his implies that the Isoquant is a negatively sloped curve. %his is because when the quantiIy oI Iactor K
(capital) is increased, the quantity oI L (labor) must be reduced so as to keep the same level oI output.



%he Iigure (12.3) depicts that an isoquant IP is negatively sloped curve. %his curve shows that as the
amount oI Iactor K is increased Irom one unit to 2 units, the units oI Iactor L are decreased Irom 20 to 15
only so that output oI 100 units remains constant.

(ii) An Isoquant that Lies Above and to the Right of Another Represents a Higher Output Level:
It means a higher isoquant represents higher level oI output.



%he Iigure 12.4 represents this property. It shows that greater output can be secured by increasing the
quantity combinations oI both the Iactors X and Y. %he producer increases the output Irom 100 units to
200 units by increasing the quantity combination oI both the X and Y. %he combination oI OC oI capital
and OL oI labor yield 100 units oI production. %he production can be increased to 200 units by increasing
the capital Irom OC to OC
1
and labor Irom OL to OL
1
.
(iii) Isoquants Cannot Cut Each Other:

%he two isoquants can not intersect each other.



II two isoquant are drawn to intersect each other as is shown in this Iigure 12.5, then it is a negation oI the
property that higher Isoquant represents higher level oI output to a lower Isoquant. %he intersection at
point E shows that the same Iactor combination can produce 100 units as well as 200 units. But this is
quite absurd. How can the same level oI Iactor combination produce two diIIerent levels oI output, when
the technique oI production remains unchanged. Hence two isoquants cannot intersect each other.

(iv) Isoquants are Convex to the Origin:

%his property implies that the marginal signiIicance oI one Iactor in terms oI another Iactor diminishes
along an ISO product curve. In other words, the isoquants are convex to the origin due to diminishing
marginal rate oI substitution.



In this Iigure 12.6 RS
KL
diminishes Irom 5:1 to 4:1 and Iurther to 3:1. %his shows that as more and
more units oI capital (K) are employed to produce 100 units oI the product, lesser and lesser units oI labor
(L) are used. Hence diminishing marginal rate oI technical substitution is the reason Ior the convexity oI
an isoquant.

(v) Each Isoquant is Oval Shaped:

%he iso product curve, is elliptical. %his means that the Iirm produces only those segments oI the iso-
product curves which are convex to the origin and lie between the ridge lines. %his is the economic region
oI production.

Isocost Lines/Outlay Line/Price Line/Factor Cost Line:

Definition:

A Iirm can produce a given level oI output using eIIiciently diIIerent combinations oI two inputs. For
choosing eIIicient combination oI the inputs, the producer selects that combination oI Iactors which has
the lower cost oI production. %he inIormation about the cost can be obtained Irom the isocost lines.

Explanation:

An isocost line is also called outlay line or price line or factor cost line. An isocost line shows all the
combinations oI labor and capital that are available Ior a given total cost to-the producer. Just as there are
inIinite number oI isoquants, there are inIinite number oI isocost lines, one Ior every possible level oI a
given total cost. %he greater the total cost, the Iurther Irom origin is the isocost line.

Example:

%he isocost line can be explained easily by taking a simple example.

Diagram/Figure:



Let us examine a Iirm which wishes to spend $100 on a combination oI two Iactors labor and capital Ior
producing a given level oI output. We suppose Iurther that the price oI one unit oI labor is $5 per day.
%his means that the Iirm can hire 20 units oI labor. On the other hand iI the price oI capital is $10 per
unit, the Iirm will purchase 10 units oI capital. In the Iig. 12.7, the point A shows 10 units oI capital used
whereas point % shows 20 units oI labor are hired at the given price. II we join points A and %, we get a
line A%. %his A% line is called isocost line or outlay line. %he isocost line is obtained with an outlay oI
$100.

Let us assume now that there is no change in the market prices oI the two Iactors labor and capita! but the
Iirm increases the total outlay to $150. %he new price line BK shows that with an outlay oI $150, the
producer can purchase 15 units oI capital or 30 units oI labor. %he new price line BK ShiIts upward to the
right. In case the Iirm reduces the outlay to $50 only, the isocost line CD shiIts downward to the leIt oI
original isocost line and remains parallel to the original price line.

%he isocost line plays a similar role in the Iirm's decision making as the budget line does in consumer's
decision making. %he only diIIerence between the two is that the consumer has a single budget line which
is determined by the income oI the consumer. Whereas the Iirm Iaces many isocost lines depending upon
the diIIerent level oI expenditure the Iirm might make. A Iirm may incur low cost by producing relatively
lesser output or it may incur relatively high cost by producing a relatively large quantity.

Marginal Rate of Technical Substitution (MRTS):

Definition:

ProI. R.G.D. Alien and J.R. Hicks introduced the concept oI RS (marginal rate oI substitution) in the
theory oI demand. %he similar concept is used in the explanation oI producers equilibrium and is named
as marginal rate of technical substitution (MR%S).

arginal rate oI technical substitution (R%S) is:

"%he rate at which one Iactor can be substituted Ior another while holding the level oI output constant".

%he slope oI an isoquant shows the ability oI a Iirm to replace one Iactor with another while holding the
output constant. For example, iI 2 units oI Iactor capital (K) can be replaced by 1 unit oI labor (L),
marginal rate oI technical substitution will be thus:

MRS AK 2 2
AL 1
Explanation:

%he concept oI R%S can be explained easily with the help oI the table and the graph, below:

Schedule:

Factor
Combinations
Units of
Labor
Units of
Capital
Units of Output of
Commodity X
MRTS of Labor
for Capital
A 1 15 150 -
B 2 11 150 4:1
C 3 8 150 3:1
D 4 6 150 2:1
E 5 5 150 1:1

It is clear Irom the above table that all the Iive diIIerent combinations oI labor and capital that is A, B, C,
D and E yield the same level oI output oI 150 units oI commodity X, As we move down Irom Iactor A to
Iactor B, then 4 units oI capital are required Ior obtaining 1 unit oI labor without aIIecting the total level
oI output (150 units oI commodity X).

%he R%S is 4:1. As we step down Irom Iactor combination B to Iactor combination C, then 3 units oI
capital are needed to get 1 unit oI labor. %he R%S oI labor Ior capital 3:1. II we Iurther switch down
Irom Iactor combination C to D, the R%S oI labor Ior capital is 2:1. From Iactor D to E combination,
the R%S oI labor Ior capital Ialls down to 1:1.

Formula:

MRTS
LK
AK
AL
It means that the marginal rate oI technical substitution oI Iactor labor Ior Iactor capital (K) (R%S
LK
) is
the number oI units oI Iactor capital (K) which can be substituted by one unit oI Iactor labor (L) keeping
the same level oI output. In the Iigure 12.8, all the Iive combinations oI labor and capital which are A, B,
C, D and E are plotted on a graph.

Diagram/Graph:



%he points A, B, C, D and E are joined to Iorm an isoquant. %he iso-product curve shows the whole range
oI Iactor combinations producing 150 units oI commodity X. It is important to point out that ail the Iive
Iactor combination oI labor and capital on an iso-product curve are technically eIIicient combinations.
%he producer is indiIIerent towards these, combinations as these produce the same level oI output.

Diminishing Marginal Rate of Technical Substitution:

%he decline in R%S along an isoquant Ior producing the same level oI output is named as diminishing
marginal rates oI technical education. As we have seen in Fig. 12.8, that when a Iirm moves down Irom
point (a) to point (b) and it hires one more labor, the Iirm gives up 4 units oI capital (K) and yet remains
on the same isoquant at point (b). So the R%S is 4. II the Iirm hires another labor and moves Irom point
(b) to (c), the Iirm can reduce its capital (K) to 3 units and yet remain on the same isoquant. So the R%S
is 3. II the Iirm moves Irom point (C) to (D), the R%S is 2 and Irom point D to e, the R%S is 1. %he
decline in R%S along an isoquant as the Iirm increases labor Ior capital is called Diminishing Marginal
Rate of %echnical Substitution.

Market Structure:

Definition of Market:
A market is a set oI conditions in which buyers and sellers meet each other Ior the purpose oI exchange
oI goods and services Ior money.

Elements of Market:
%he essentials oI a market are:
(i) Presence oI goods and services to be exchanged.

(ii) Existence oI one or more buyers and sellers.

(iii) A place or a region where buyers and sellers oI a good get in close touch with each other.

Types of Market/Market Model:

Markets are classified according to the number oI Iirms in the market and by the commodity to be
exchanged. %he economists on the basis oI variation in the Ieatures oI market describe four market
models:
(i) PerIect Competition.
(ii) Pure onopoly.
(iii) onopolistic Competition.
(iv) Oligopoly.

In the analysis oI each market model, it is examined as to what determines the equilibrium price, output
and proIit levels Ior the individual Iirm and Ior the industry, in this chapter, we discuss the most
important oI the various market models that is perIect competition.

Perfect Competition:

Definition:

%he concept oI perfect competition was Iirst introduced by Adam Smith in his book "Wealth oI Nations".
Later on, it was improved by Edgeworth. However, it received its complete Iormation in Frank Kight's
book "Risk, Uncertainty and ProIit" (1921).

Leftwitch has deIined market competition in the Iollowing words:

"PreIect competition is a market in which there are many Iirms selling identical products with no Iirm
large enough, relative to the entire market, to be able to inIluence market price".

According to Bllas:

"%he perIect competition is characterized by the presence oI many Iirms. %hey sell identically the same
product. %he seller is a price taker".

%he main conditions or features oI perIect competition are as under:

Features/Characteristics or Conditions:

(1) Large number of firms. %he basic condition oI perIect competition is that there are large number oI
Iirms in an industry. Each Iirm in the industry is so small and its output so negligible that it exercises little
inIluence over price oI the commodity in the market. A single Iirm cannot inIluence the price oI the
product either by reducing or increasing its output. An individual Iirm takes the market price as given and
adjusts its output accordingly. In a competitive market, supply and demand determine market price. %he
Iirm is price taker and output adjuster.

(2) Large number of buyers. In a perIect competitive market, there are very large number oI buyers oI
the product. II any consumer purchases more or purchases less, he is not in a position to aIIect the market
price oI the commodity. His purchase in the total output is just like a drop in the ocean. He, thereIore, too
like the Iirm, is a price taker.

In the Iigure (15.1) PK is the market price determined by the market Iorces oI demand and supply. %he
price taker Iirm has to adjust and sell its output at Price PK or OE.
Diagram/Figure:



(3) The product is homogeneous. Another provision oI perIect competition is that the good produced by
all the Iirms in the industry is identical. In the eyes, oI the consumer, the product oI one Iirm (seller) is
identical to that oI another seller. %he buyers are indiIIerent as to the Iirms Irom which they purchase. In
other words, the cross elasticity between the products oI the Iirm is inIinite.

(4) No barriers to entry. %he Iirms in a competitive market have complete Ireedom oI entering into the
market or leaving the industry as and when they desire. %here are no legal, social or technological!
barriers Ior the new Iirms (or new capital) to enter or leave the industry. Any new Iirm is Iree to start
production iI it so desires and stop production and leave the industry iI it so wishes. %he industry, thus, is
characterized by Ireedom oI entry and exit oI Iirms.

(5) Complete information. Another condition Ior perIect competition is that the consumers and
producers possess perIect inIormation about the prevailing price oI the product in the market. %he
consumers know the ruling price, the producers know costs, the workers know about wage rates and so
on. In brieI, the consumers, the resource owners have perIect knowledge about the current price oI the
product in the market. A Iirm, thereIore, cannot charge higher price than that ruling in the market. II it
does so, its goods will remain unsold as buyers will shiIt to some other seller.

(6) Profit maximization. For perIect competition to exist, the sole objective oI the Iirm must be to get
maximum proIit.

Importance:

PerIect competition model is hotly debated in economic literature. It is argued that the model is based on
unrealistic assumptions. It is rare in practice. %he deIenders oI the model argue that the theory oI perIect
competition has positive aspect and leads us to correct conclusions. %he concept is useIul in the analysis
oI international trade and in the allocation oI resources. It also makes us understand as to how a Iirm
adjusts its output in a competitive world.

Distinction Between Pure Competition and Perfect Competitions:

For a pure competition to exist, there are three main requisites, i.e., (1) homogeneity oI product (2) large
number oI Iirms and (3) ease oI entry and exist oI Iirms.

A perfect competition, on the other hand, is made up oI all the six postulates stated earlier.

Equilibrium of the Firm Under Perfect Competition or Marginal Revenue Marginal Cost (MR
MC) Rule:

Definition and Explanation:

A Iirm under perIect competition Iaces an inIinitely elastic demand curve or we can say Ior an individual
Iirm, the price oI the commodity is given in the market. %he Iirm while making changes in the amounts oI
variable Iactor evaluates the extra cost incurred on producing extra unit C (arginal Cost).

It also examines the change in total receipts which results Irom the sale oI extra unit oI production R
(arginal Revenue). So long as the additional revenue Irom the sale oI an extra unit oI product (R) is
greater than the additional cost (C) which a Iirm has to incur on its production, it will be in the interest
oI the Iirm to increase production.

In economic terminology, we can say, a Iirm will go on expanding its output so long as the marginal
revenue oI any unit is greater than its marginal cost. As production increases, marginal cost begins to
increase aIter a certain point. When both marginal revenue and marginal cost are equal, the Iirm is in
equilibrium. %he Iirm at this equilibrium point is cither ensuring maximum proIit or minimizing losses.
%his is shown with the help oI a diagram below:

Diagram/Figure:



In the Iigure (15.2) quantity oI output is measured along OX axis and marginal cost and marginal revenue
on OY axis. %he marginal cost curve cuts the marginal revenue curve at two points K and %.

%he competitive Iirm is in equilibrium, at both these points as marginal cost equals marginal revenue. %he
Iirm will not produce O quantity oI good because Ior O output, the marginal cost is higher than
marginal revenue. arginal cost curve cuts the marginal revenue curve Irom above. %he Iirm incurs loss
equal to the black shaded area Ior producing 50 units (O) oI output.

As production is increased Irom 50 units to 350 units (Irom O to OS) marginal cost decreases at early
levels oI output and then increases thereaIter. %he marginal cost curve cuts the marginal revenue curve
Irom below at point %. %he shaded portion between to S level oI output shows proIit on production.
When a Iirm produces OS quantity oI output; it earns maximum proIit. %he point % where R C is
the point oI maximum proIit.

In case, the Iirm increases the level oI output Irom OS, the additional output adds less to Its revenue than
to its cost. %he Iirm undergoes losses as is shown in the shaded area.

Summing up, proIit maximization normally occurs at the rate oI output at which marginal revenue equals
marginal cost. %his golden rule holds good Ior all market structures. As regards the absolute proIits and
losses oI the Iirm, they depend upon the relation between average cost and average revenue oI the Iirm.

Short Run Equilibrium of the Price Taker Firm Under Perfect Competition:

Definition and Explanation:

By short run is meant a length oI time which is not enough to change the level oI Iixed inputs or the
number oI Iirms in the industry but long enough to change the level oI output by changing variable inputs.

In short period, a distinction is made oI two types oI costs (i) Iixed cost and (ii) variable cost.

%he fixed cost in the Iorm oI Iixed Iactors i.e., plant, machinery, building, etc. does not vary with the
change in the output oI the Iirm. II the Iirm is to increase or decrease its output, the change only takes
place in the quantity oI variable resources such as labor, raw material, etc.

Further, in the short run, the demand curve Iacing the Iirm is horizontal. No new Iirms enter or leave the
industry. %he number oI Iirms in the industry, thereIore, remain the same. Under perIect competition, the
Iirm takes the price oI the product as determined in the market. %he Iirm sells all its output at the
prevailing market price. %he firm, in other words, is a price taker.

Equilibrium of a Competitive Firm:

%he short-run equilibrium oI a Iirm can be easily explained with the help oI marginal revenue
marginal cost approach or (MR MC) rule.

arginal revenue is the change in total revenue that occurs in response to a one unit change in the
quantity sold. arginal cost is the addition to total cost resulting Irom the additional oI marginal unit.
Since price is given Ior the competitive Iirm, the average revenue curve oI a price taker Iirm is identical to
the marginal curve. Average revenue (AR) thus is equal to marginal revenue (R) is equal to price (R
AR Price).

According to the marginal revenue and marginal cost approach or (R C) rule , a price taker Iirm is
in equilibrium at a point where marginal revenue (R) or price is equal to marginal cost %he point where
R C Price, the Iirm produces the best level oI output. From this it may not be concluded that the
perIectly competitive Iirm at the equilibrium level oI output (R C Price) necessarily ensures
maximum proIit. %he Iact is that in the short period, a Iirm at the equilibrium level oI output is Iaced with
Iour types oI product prices in the market which give rise to Iollowing results:

(i) A Iirm earns supernormal proIits.
(ii) A Iirm earns normal proIits.
(iii) A Iirm incurs losses but does not close down.
(iv) A Iirm minimizes losses by shutting down. All these short run cases oI proIits or losses are
explained with the help oI diagrams.

Determining Profit from a Graph:

(1) Profit Maximizing Position:

A Iirm in the short run earns abnormal proIits when at the best level oI output, the market price exceeds
the short run average total cost (SA%C). %he short run proIit maximizing position oI a purely competitive
Iirm is explained with the help oI a diagram.

Diagram/Graph:



In the Iigure (15.3), output is measured along OX axis and revenue / cost on OY axis. We assume here
that the market price is equal to OP. A price taker Iirm has to sell its entire output at this prevailing
market price i.e. OP. %he Iirm is in equilibrium at point L. Where C R. %he inter section oI C and
R determine the quantity oI the good the Iirm will produce.

AIter having determined the quantity, drop a vertical line down to the horizontal axis and see what the
average total cost (A%C) is at that output level (point N). %he competitive Iirm will produce ON quantity
oI output and sell at market price OP. %he total revenue oI the Iirm at the best level oI output ON is equal
to OPLN. Whereas the total cost oI producing ON quantity oI output is equal to OKN. %he Iirm is
earning supernormal proIits equal to the shaded rectangle KPL. %he per unit proIit is indicated by the
distance L or PK.

It may here be noted that a Iirm would not produce more than ON units because producing another unit
adds more to the cost than the Iirm would receive Irom the sale oI the unit (C ~ R). %he Iirm would
not stop short oI ON output because producing another unit adds more to the revenue than to cost (R ~
C). Hence, ON is the best level oI output where proIit oI the Iirm is maximum.

(2) Zero Profit of a Firm:

A Iirm, in the short run, may be making zero economic proIit or normal economic proIit. It may here be
remembered that although economic proIit is zero, all the resources including entrepreneurs are being
paid their opportunity.

So they are getting a normal proIit the case oI normal proIits oI a Iirms at break
even price is explained with the help oI the diagram 15.4.



We assume in the Iigure (15.4) that OP is the prevailing market price and PK is the average revenue,
marginal revenue curve. At point K, which is the break even price Ior a Competitive Iirm, the R, C
and A%C are all equal. %he Iirm produces O output-and sells at market price OP. %he total revenue oI
the Iirm to equal is the area OPK. %he total cost oI producing O output also equals the area OPK.
%he Iirm is earning only normal proIits. It is a situation in which the resources employed by the Iirm are
earning just what they could-earn in some other alternative occupations.

(3) Loss Minimizing Case:

%he Iirm in the short rue is minimizing tosses iI the market price is smaller than average total cost but
larger than average variable cost. %he loss minimizing position oI a price taker Iirm is explained with the
help oI a diagram.



We assume in the Iigure (15.5) that the market price is QP. %he Iirm is in equilibrium at point N where
R C. %he Iirm's best level oI output is OK which is sold at unit cost OP. %he total revenue oI the
Iirm is equal to the area OPNK. %he total cost oI producing OK quantity oI output is equal to O%SK. %he
Iirm is suIIering a net loss equal to the shaded area P%SN.

%he Iirm at price OP in the market is covering its Iull variable cost and a part oI the Iixed cost. %he loss oI
part oI Iixed cost equal to the shaded area P%SN is less than, the Iirm would incur by closing down. In
case oI shut down, the Iirm has to bear the total Iixed cost E%SF. %he Iirm thus by producing OK output
and selling at OP price is minimizing losses. Summing up, in the short run the Iirm will not go out oI
business Ior as long as the loss m staying the business is less than the loss Irom closing down.

(4) Short Run Shut Down:

%he price taker Iirm in the short-run minimizes losses by closing it down iI the market price is less than
average variable cost. %he shut down position oI a Competitive Iirm is explained with the help oI a
diagram.



In this Iigure (15.6) we assume that the market price is OP. %he Iirm, is in equilibrium at point Z where
R C. %he Iirm produces OK output and sells at OP unit cost. %he total revenue oI the Iirm is equal
to the area OPZK. Whereas .the total cost producing OK output is O%FR. %he Iirm is suIIering a net loss
oI total Iixed cost equal to the area P%FZ. %he Iirm at point Z is just covering average variable costs.

II the price Ialls below Z, the competitive Iirm will minimize its losses by closing down. %here is no level
oI output which the Iirm can produce and realize a loss smaller than its Iixed costs. It is thereIore a shut
down point Ior the Iirm. Operate When Price is ~ average variable cost.

Short Run Supply Curve of a Price Taker Firm:

Definition and Explanation:
n a competitive market, the supply curve of a firm is derived Irom its marginal cost curve. Supply curve
is that portion oI the marginal cost curve which lies above the average variable cost curve.
As we already know, the aim oI the Iirm is to maximize proIits or minimize losses. %he proIits are
increased it the diIIerence between total receipts and total costs is maximized. When a Iirm undertakes the
production oI a particular commodity, it has to pay remuneration to all the Iactors oI production
employed. %he remuneration or cost oI the Iirm Ior a short period can be divided into two parts, Iixed
costs and variable costs. II Irom the sale oI the commodity produced, a Iirm is earning much more than
what it has to spend on it. We say a Iirm is earning abnormal proIits iI the total revenue oI the Iirm is
equal to total cost, the Iirm is getting normal proIits. In both these cases, it is proIitable Ior the Iirm to
produce the commodity. But iI the total receipts Iall short oI total costs, then three situations can arise.
(i) A Iirm is not in position to meet its variable costs.
(ii) A Iirm is able to cover its variable costs.
(iii) A Iirm is covering its Iull variable costs and a part oI the Iixed costs.
Let us explain all these situations with the help oI a curve.
Diagram:

(1) In the Iigure. (15.7) there are three costs curves, AVC curve, A%C curve and C curve. A%C curve
includes the average variable cost and average Iixed cost oI a Iirm. Average variable cost is represented
by the AVC curve which lies below the A%C curve. Let us suppose now that at price O, a Iirm supplies
an output equal to 01 because R C at point I.
%he total receipts oI the Iirm at O price are thus, equal to OIL, while the total costs are equal to
OIKN. At this price, a Iirm is undergoing too much losses which are represented by the area LKN. It is
not even meeting its Iull variable cost as the AVC curve lies much above this price line. A Iirm shall have
to close down its operations Ior minimizing losses in the short run (shut down cases).
(2) At price OF, a Iirm is in equilibrium at point E where R P AR. It produces OD amount oI output
and is just able to cover its variable cost. %he total receipts oI the Iirm at OF price are equal to ODEF and
the total cost ODGH. As the total receipts oI-the Iirm Iall short oI total cost, so it Is not advantageous Ior
the Iirm to carry on production in the short run. %he Iirm shall close down its operation as the Iull Iixed
cost equal to the area FHGE is not met. %he point E where R C minimum oI AVC is also a shut
down point oI the Iirm.
(3) In case the price settles somewhere between F and G, then the Iirm will be meeting its Iull variable
costs and a part oI the Iixed costs. It, may preIer to produce because iI the concern is closed down the
whole oI the Iixed cost is to be met. %his, oI course can happen in a short period. When the period is long
the total receipts oI the Iirm must be equal to total cost and the Iirm must earn normal proIit.
(4) II the price in the market is OG, the Iirm is in equilibrium at point B. Here the total receipts oI the
Iirm, i.e., OABG are equal to the total cost, i.e., OABG. A Iirm is earning normal proIits and it is
proIitable Ior it to carry on production. By normal proIits in economics we mean the level oI proIit which
is just suIIicient to induce an entrepreneur to stay in the industry. %he amount is equal to the remuneration
which an entrepreneur can get in an alternative occupations. II the entrepreneur is not paid the amount
equal to this normal proIit, he will move to the other alternative industry where he could got this amount.
II price, rises above OG, then Iirm is getting abnormal proIits. For instance, the Iirm is producing best
level oI output by equating R C at point U and selling at price OZ, the total revenue oI the Iirm will
be OWUZ and total cost OWVP. %here is thus an abnormal proIit equal to PVU2.
Summing up, we can say, that iI price Ialls below the lowest point on the AVC curve, the Iirm will not
produce any output because it is not able to cover even its total variable costs. But iI the price is such that
it covers its total variable costs, then the Iirm may carry on production Ior a short period. So is also the
case when it covers its Iull variable costs and a part oI the Iixed costs. In the long period, iI the Iirm does
not cover its Iull costs, it will have to dose down its operations sooner or later. So we conclude that the
supply curve oI the Iirm that can be regarded as that portion oI the C curve which lies above the AVC
curve and not which lies below the AVC curve because it is only at the lowest point on the AVC curve
that some output is Iorthcoming and not below this point.
The supply curve of the firm or the rising portion of the MC curve which lies above the AVC curve
can be split up into two parts. One part consists of that portion which lies above the lowest point of
the ATC curve. If the price line representing MR AR intersects the MC curve at any point on this
rising portion, the firm will be earning abnormal profit (see fig. 15.7). The second part of the supply
curve of the firm extends from the lowest point of the AVC curve to the lowest, point of the ATC
curve. If price line representing MR AR passes through the lowest point of the AVC curve, the
firm is covering only total variable costs. If the price line cuts the MC curve at any point above the
lowest point of the AVC curve and below the lowest point of ATC curve, the firm will be meeting its
total variable costs and a part of the fixed costs but not the total costs. The total costs are met only
when the price line forms a tangent to the ATC curve.

Long Run Equilibrium of the Price Taker Firm:

Definition:

"All the Iirms in a competitive industry achieve long run equilibrium when market price or marginal
revenue equals marginal cost equals minimum oI average total cost."

Formula:

Price Marginal Cost Minimum Average Total Cost

Explanation:

%he long run is a period oI time during which the Iirms are able to adjust their outputs according to the
changing conditions. II the demand Ior a product increases, all the Iirms have suIIicient time to expand
their plant capacities, train and engage more labor, use more raw material, replace old machines, purchase
new equipments, etc., etc.

II the demand Ior a product declines, the Iirms reduce the number oI workers on the pay roll, use less raw
material. In short, all inputs used by a Iirm are variable in the long run. It is assumed that all the Iirms in
the competitive industry are producing homogeneous product and an individual Iirm cannot aIIect the
market price. It takes the market price as given. It is also assumed that all the Iirms in a competitive
industry have identical cost' curves. %he industry it is assumed is, a constant cost industry. In the long run,
it is Ior Iurther assumed that all the Iirms in a competitive industry have access to the same technology.

When the period is long and proIit level oI the competitive industry is high, then new Iirms enter the
industry. II the proIit level is below the competitive level, the Iirm then leave the industry. When all the
competitive Iirms earn normal proIit, then there is no tendency Ior the new Iirms to enter or leave the
industry. %he Iirms are then in the long run equilibrium.

Diagram:

%he case oI long-run equilibrium oI a Iirm can be easily explained with .the help oI a diagram given
below:



In the Iigure (15.9), the Iirm is in the long run equilibrium at point K, where price or marginal revenue
equals long-run marginal cost equals minimum oI long run average cost. %he average revenue per unit
cost oI the Iirm and its marginal revenue at price OP are the same. %he Iirm at equilibrium point K,
produces the best level oI output OL and sells at price OP per unit. %he total revenue oI the Iirm is equal
to the area OPKL.

%he total cost oI producing OL quantity oI output is also equal to the area OPKL. %he Iirm is earning only
normal proIits. At price OP, there is no tendency Ior the new Iirms to enter or leave the industry.

%his can be proved by taking prices higher or lower price than OP. II the market price in the long run
happens to be OR, the Iirm would be making more than normal proIits. %he new Iirms attracted by proIit
will enter the industry. %he supply oI the commodity will increase which derives the market price down to
the OP level. %he Iirm here makes only normal proIits.

In case, a Iirm is Iaced with a market price OZ, the Iirm is then covering its Iull variable cost. As the Iirm
is suIIering a net loss at price OZ, it will leave the industry. So in the long run, price must be equal to OP
which is the minimum average to cost oI the Iirms.

At price OP, all the identical Iirms to the industry earn only normal proIit. %here is no tendency Ior the
new Iirms to enter or leave the industry provided price equals marginal revenue equals marginal cost
equals minimum average total cost oI the Iirms.

Price MR MC Minimum of LATC


Long Run Industry Equilibrium:

Since all the competitive Iirms in the long run make normal proIits, are oI the optimum size and there is
no tendency Ior the new Iirms to enter or leave the industry, they are, thereIore, in equilibrium. When all
the identical Iirms in the industry are in a state oI Iull equilibrium equating price or marginal revenue,
equating marginal cost equating minimum oI average total cost, the industry itselI is then in equilibrium.

When the industry is in the long run equilibrium, there is an optimum allocation oI resources. %he
consumers get the. products at the lowest possible price as, the goods are produced at minimum price in
the long run.

Price Determination under Perfect Competition:
Definition and Explanation:
Dr. Alfred Marshall was the Iirst economist who pointed out that the pricing problem should be studied
Irom the view point oI time. He distinguished three Iundamental time periods in the determination oI
price:
(1) arket price.
(2) Short run normal price.
(3) Long run normal price.

arshall has stated that it is wrong to say that demand alone or supply alone determines price. It is both
demand and supply which determine price. In the words oI Marshall:

"%he shorter, the period which one considers, the greater must be the share oI our attention which is given
to the inIluence oI demand on value and longer the period, the more important will be the inIluence oI
cost oI production on value".

Actual value at any time the market value as it is oIten called is oIten inIluenced by passing events and is
short lived than by those which work persistently. But in the log run, these IitIul and irregular causes in a
large measure eIIace one another inIluence so that in the long run persistent causes dominate value
completely. Stiller is right when he says that arshall has done a great service to economics by
introducing time element in pricing.

Market Price:
Definition of Equilibrium:
In a market, there are two sets oI Iorces tending in the opposite direction. On the one side, there are large
number oI buyers who compete with one another Ior the purchase oI commodities at lower prices.
Competition amongst the buyers tends to raise the price. On the other side, there are large number oI
sellers who compete with one another Ior the, sale oI commodities at higher prices. Competition amongst
the sellers tends to lower the price. When the pressure oI these two Iorces is equal in the opposite
direction, i.e., when the quantity oIIered Ior sale is just equal the quantity demanded at a particular price,
the market is said to be in equilibrium.

Definition of Market Price:

%he price at which the amounts demanded and supplied is exactly equal, is. Called the market price.
Explanation:

%he market equilibrium or the market price is not something Iixed. It is subject to Iluctuations with the
increase or decrease in demand or with the increase or decrease in supply. arket price or the very short
run price is the price which tends to prevail in the market at any particular, time. It may change Irom hour
to hour or Irom day to day. It is, in Iact, the result oI temporary equilibrium, between the demand Ior and
the supply oI a commodity at a certain time, e.g., iI the demand Ior a commodity increases per unit oI
time, supply remaining the same, prices go up. We can, thus, call the market price as the changing
equilibrium.

When the period is very short, say an hour, or, a Iew hours, the supply oI the commodities iI demanded
more cannot be increased with the Iurther production oI goody. %he supply can only be brought Irom the
stock already available Ior sale. In a very short period, the cost oI production has a very negligible
inIluence on the market price. II the commodities are perishable, like Iish, Iruits, etc., and there is no
arrangement available Ior placing them in cold storages, then the cost oI production has practically no
inIluence on price and there is also no reserve-price on the part oI the sellers.

II the commodities can be kept Ior a longer period, then it has an indirect inIluence on market price. II
price Ialls lower than the reserve price, the commodities will not be brought Ior sale but will be kept in
store hoping to dispose them oII when their prices cover the cost oI production. %he analysis oI the
market equilibrium or the market price stated above can be discussed in more detail.

(1) Market Price of Perishable Commodities:

In a case oI a commodity which, is perishable, the cost oI production has practically no inIluence on the
market price. %he whole oI the stock has to be disposed oII at the prevailing price. Let us suppose a
perishable commodity like Iish is brought Ior sale in the market to the amount oI 50 kilograms. %he total
quantity oI Iish demanded by all individuals in the market at various prices per day is as Iollows:

Schedule:

Price (in $) Per Kg. Amount Supplied Per
Day
"uantity in Kg.
Demanded Per Day
50 50 1
40 50 10
30 50 15
20 50 23
10 50 50

From the schedule given above, the reader can understand that iI the seller wishes to sell the whole oI the
stock, it can be sold at $10 per kilogram. As in a perIect market, there can be only one price Ior a
particular commodity, so the buyers who are willing to buy at higher price, enjoy consumer's surplus. %he
price determination in the market period can be illustrated with the help oI a diagram. The equilibrium
market price is where demand and supply curves intersect.

Diagram/Graph:



In the graph (15.13) quantity is measured along OX axis and price along OY axis. As the supply oI a
perishable commodity is Iixed and cannot be held back, thereIore, the market period supply curve (SC).
SS will be a vertical straight line. %he market demand curve DD' intersects the market supply curve at
point . S ($10) is the market price at which the total quantity oI Iish is sold in the market.

Let us suppose that demand Ior Iish rises due to strike on the part oI the meat sellers, the new demand
curve D
1
D
1
intersects the market supply curve at point LLS which is equal to $50 will be new market
price. II the demand Ialls, the new demand curve D
2
D
2
cuts the supply curve at point R. $30 which is
equal to $5 is the new equilibrium price.

(2) Market Price of Non-Perishable Commodities:

When the commodities are not perishable, the stock can be kept in store Ior certain period. II prices rise
and the sellers think it proIitable to sell, then the whole oI the stock can be brought in the market Ior sale.
II prices Iall and the sellers do not think it advantageous to sell, then a part or whole oI the stock can be
withheld with a view to sell it at some Iuture date when the prices rise. AIter haggling and bargaining, a
price is established which just clears the market. At this price, the total amount demanded is exactly equal
to the total amount supplied. %his can be proved with the help oI a schedule and a diagram.

Schedule:

"uantity in "uintals
Demanded (Per Week)
Price in ($) Per "uintals
"uantity in "uintals Supplied
(Per Week)
Pressure on
Price
20 30 200 Falling
60 25 150 Falling
90 20 130 Falling
100 15 100 Neutral
140 10 75 Rising
190 5 25 Rising

In the schedule given above, when the price oI a commodity is $15 per quintal, the total, quantity
demanded per week is just equal to the total quantity supplied, i.e., 100 quintals.

Diagram:



It can also be illustrated with the help oI a diagram. In the Fig. (15.14) SSN is the supply curve oI non-
perishable commodity in the very short period. OZ is the quantity oI goods which can be brought into the
market Ior sale. DD
/
is the market demand curve which intersects the market. supply curve at point P. P
which is equal to $15 is the equilibrium price or the market price point P. P which is equal to $15 is the
equilibrium price or the market price and O the equilibrium amount II the demand rises, the new market
demand curve intersects the supply curve at point R. RZ then will be the, market price. NS position oI the
supply curve is a vertical line showing that even iI price rises, the quantity cannot be increased. However,
the price will go up with the increase in demand.

II the demand Ialls, the new demand curve D
2
D
2
cuts. %he supply curve at point %. %H then is the market
price. It shows that at lower price, less commodity is oIIered Ior sale. In this case, it is OH quantity only
which is brought into the market Ior sale at %H price.

Long Run Normal Price and the Adjustment of Market Price to the Long Run Normal Price:

Definition and Explanation:
When we speak oI a long period, we do not mean an interval oI time in which we all may be dead. By
long run is meant the period in which the Iactors oI production can be adjusted to changes in demand. %he
long run period diIIers with diIIerent industries. In some industries, the preparation oI the plan, the
expansion, construction oI the new building, installation oI new machinery, training oI new labor may
take only a Iew months and in others, it may take a Iew years.
In the long run, the price will be determined at a point where the demand curve and the long run supply
curve intersect each other. %he shape oI the long run supply curve will, however, be diIIerent with
diIIerent industries. II the industry is subject to increasing cost, the long run supply curve will slant
upward Irom leIt to right. II the industry is subject to diminishing cost, it will Iall downward Irom leIt to
right. II the industry is subject to constant cost, it will be parallel to the quantity axis.
Let us examine now the determination oI long run price under the above three conditions and also see as
to how the market price adjusts itselI Ior the long run normal price.
Dynamic Changes and Industry Equilibrium:
(1) Increasing Cost Industry and Long Period Price Determination:
%he long run supply curve in increasing cost industry slants upward Irom leIt to right but the rise is less
steep as compared to short period supply curve. %he market price is determined at a point where the long
run supply curve cuts the demand curve as is illustrated below.
Diagram:

In this Iig. 15.16 market supply curve (SC), short period supply curve (SPC), long period supply curve
(LPSC), pass through the point P. %he market price, short period price and the long run normal price thus
is equal to ON.
Let us suppose that there is once Ior all increase in the market demand. %he new demand curve D
1
D
1

intersects the market supply cure, short, period supply curve, and long period supply curve (LPSC) at
points Z, R, A, respectively. %he new market price with be equal to OD, the short period price equal to
OC and long period price equal to OE.

%he market price OD is higher than short period normal price and long run normal price. %he short period
normal price OC is lower than the market price but higher than long run normal price. %he long run
normal price OE is the lowest oI the two but is higher than the original market price ON. How much the
long run price will diIIer Irom the market price depends upon the supply condition in a particular
industry. %he Iact in that the market price oscillates round the long run normal price.

(2) Decreasing Cost Industry:

In case oI decreasing cost industry, the long run supply curve will have a negative slope. %he price will be
determined at a point where the market demand curve intersects the long period supply curve as shown
below.

Diagram:



In Fig. (15.17) market supply curve, long period supply curve and demand curve intersect at point P. ON
is the original market price. II demand rises, the new demand curve D
1
D
1
intersects the market supply,
curve at point E and long run supply curve at point R. OQ then will be the new market price and so the
long run normal price. %he long run normal price OS is now lower than the original market price ON. %he
market supply increases Irom OK to O% in the long run.

(3) Constant Cost Industry:

II the industry is subject to constant cost, the long run supply curve will be a horizontal straight line
parallel to the base axis.

Diagram:



In Fig. 15.18 long period supply curve, market supply curve and the market demand curve pass through
point E, ON is thus the original! market price. II demand rises, the new market price will be higher than
the original market price. It is OS in the diagram. In the long run, however, the price Ialls to ON because
the long period supply curve is a horizontal straight line. %he quantity supplied increases Irom O to OK.

We, thereIore, conclude by saying that the long run normal price will be higher than, lower than or
remains equal to the original market price depending open the additional supply which can be acquired
according to the changed conditions in the long run.

Government Intervention in the Market

n a free market economic system, scarce resources are allocated through the price mechanism
where the preferences and spending decisions of consumers and the supply decisions of businesses
come together to determine equilibrium prices The free market works through price signals When
demand is high, the potential profit from supplying to a market rises, leading to an expansion in supply
(output to meet rising demand from consumers Day to day, the free market mechanism remains a
tremendously powerful device for determining how resources are allocated among competing ends
Intervention in the market
%he government may choose to intervene in the price mechanism largely on the grounds oI wanting to
change the allocation oI resources and achieve what they perceive to be an improvement in economic
and social welIare. All governments oI every political persuasion intervene in the economy to
inIluence the allocation oI scarce resources among competing uses
What are the main reasons for government intervention?
%he main reasons Ior policy intervention are:
O %o correct Ior market failure
O %o achieve a more equitable distribution of income and wealth
O %o improve the performance of the economy
Options for government intervention in markets
%here are many ways in which intervention can take place some examples are given below
Government Legislation and Regulation
Parliament can pass laws that Ior example prohibit the sale oI cigarettes to children, or ban smoking
in the workplace. %he laws oI competition policy act against examples oI price-Iixing cartels or other
Iorms oI anti-competitive behaviour by Iirms within markets. Employment laws may oIIer some legal
protection Ior workers by setting maximum working hours or by providing a price-Iloor in the labour
market through the setting oI a minimum wage.
%he economy operates with a huge and growing amount oI regulation. %he government appointed
regulators who can impose price controls in most oI the main utilities such as telecommunications,
electricity, gas and rail transport. Free market economists criticise the scale oI regulation in the
economy arguing that it creates an unnecessary burden oI costs Ior businesses with a huge amount oI
red tape damaging the competitiveness oI businesses.
Regulation may be used to introduce fresh competition into a market Ior example breaking up the
existing monopoly power oI a service provider. A good example oI this is the attempt to introduce
more competition Ior British %elecom. %his is known as market liberalisation.
Direct State Provision of Goods and Services
Because oI privatization, the state-owned sector oI the economy is much smaller than it was twenty
years ago. %he main state-owned businesses in the UK are the Royal ail and Network Rail.
State Iunding can also be used to provide merit goods and services and public goods directly to the
population e.g. the government pays private sector Iirms to carry out operations Ior NHS patients to
reduce waiting lists or it pays private businesses to operate prisons and maintain our road network.
Fiscal Policy Intervention
Fiscal policy can be used to alter the level of demand Ior diIIerent products and also the pattern of
demand within the economy.
(a) Indirect taxes can be used to raise the price oI de-merit goods and products with negative
externalities designed to increase the opportunity cost oI consumption and thereby reduce consumer
demand towards a socially optimal level
(b) Subsidies to consumers will lower the price oI merit goods. %hey are designed to boost
consumption and output oI products with positive externalities remember that a subsidy causes an
increase in market supply and leads to a lower equilibrium price
(c) Tax relief: %he government may oIIer Iinancial assistance such as tax credits Ior business
investment in research and development. Or a reduction in corporation tax (a tax on company proIits)
designed to promote new capital investment and extra employment
(d) Changes to taxation and welfare payments can be used to inIluence the overall distribution oI
income and wealth Ior example higher direct tax rates on rich households or an increase in the value
oI welIare beneIits Ior the poor to make the tax and beneIit system more progressive
Intervention designed to close the information gap
OIten market Iailure results Irom consumers suIIering Irom a lack of information about the costs and
beneIits oI the products available in the market place. Government action can have a role in
improving information to help consumers and producers value the true` cost and/or beneIit oI a good
or service. Examples might include:
O Compulsory labelling on cigarette packages with health warnings to reduce smoking
O Improved nutritional inIormation on Ioods to counter the risks oI growing obesity
O Anti speeding television advertising to reduce road accidents and advertising campaigns to
raise awareness oI the risks oI drink-driving
O Advertising health screening programmes / inIormation campaigns on the dangers oI addiction
%hese programmes are really designed to change the ~perceived costs and benefits oI consumption
Ior the consumer. %hey don`t have any direct eIIect on market prices, but they seek to inIluence
demand and thereIore output and consumption in the long run. OI course it is diIIicult to identiIy
accurately the eIIects oI any single government inIormation campaign, be it the campaign to raise
awareness on the Aids issue or to encourage people to give up smoking. Increasingly adverts are
becoming more hard-hitting in a bid to have an eIIect on consumers.
The effects of government intervention
One important point to bear in mind is that the eIIects oI diIIerent Iorms oI government intervention in
markets are never neutral Iinancial support given by the government to one set oI producers rather
than another will always create winners and losers. %axing one product more than another will
similarly have diIIerent eIIects on diIIerent groups oI consumers.
The law of unintended consequences
Government intervention does not always work in the way in which it was intended or the way in
which economic theory predicts it should. Part oI the Iascination oI studying Economics is that the
law oI unintended consequences oIten comes into play events can aIIect a particular policy, and
consumers and businesses rarely behave precisely in the way in which the government might want!
We will consider this in more detail when we consider government failure.
1udging the effects of intervention - a useful check list
%o help your evaluation oI government intervention it may be helpIul to consider these questions:
Efficiency of a policy: i.e. does a particular intervention lead to a better use oI scarce resources
among competing ends? E.g. does it improve allocative, productive and dynamic eIIiciency? For
example - would introducing indirect taxes on high Iat Ioods be an eIIicient way oI reducing some oI
the external costs linked to the growing problem oI obesity?
Effectiveness of a policy: i.e. which government policy is most likely to meet a speciIic economic or
social objective? For example which policies are likely to be most eIIective in reducing road
congestion? Which policies are more eIIective in preventing Iirms Irom exploiting their monopoly
power and damaging consumer welIare? Evaluation can also consider which policies are likely to have
an impact in the short term when a quick response Irom consumers and producers is desired. And
which policies will be most cost-eIIective in the longer term?
Equity effects of intervention: i.e. is a policy thought oI as Iair or does one group in society gain
more than another? For example it is equitable Ior the government to oIIer educational maintenance
allowances (payments) Ior 16-18 year olds in low income households to stay on in education aIter
GCSEs? Would it be equitable Ior the government to increase the top rate oI income tax to 50 per cent
in a bid to make the distribution oI income more equal?
Sustainability of a policy: i.e. does a policy reduce the ability oI Iuture generations to engage in
economic activity? Inter-generational equity is an important issue in many current policy topics Ior
example decisions on which sources oI energy we rely on in Iuture years.

What is Monopolistic/Imperfect Competition?

Definition:

Monopolistic/mperfect competition as the name signiIies is a blend oI monopoly and competition. It is a
systematic and realistic theory oI price analysis in this imperIectly competitive world.

onopolistic competition is a market situation in which there are relatively large number oI small Iirms
which produce or sell similar but not identical commodities to the customers.

According to Leftwitch:

"onopolistic competition is a market situation in which there are many sellers oI a particular product,
but the product oI each seller is in some way diIIerentiated in the minds oI consumers Irom the product oI
every other seller".

In the words oI 1.S. Bain:

"onopolistic competition is Iound in the industry where there is a large number oI small sellers selling
diIIerentiated but close substitute products".

Oligopoly:

In case the number oI Iirms is small and the action taken by one Iirm is Iollowed by rival Iirms in the
market, it is then to be studied within a separate Iramework oI monopolistic competition called ligopoly.

According to Chamberlin, iI all the Iirms produce identical goods, they can be easily categorized and
called an industry.

In case, the number oI Iirms is Iairly large say 20, 40, 60 and they produce some what similar goods, it is
then useIul to group these Iirms together and call them a product group oI industry. We in this chapter,
however, use 'product group' oI 'industry' in the same sense to avoid complication.

Examples of Monopolistic Competition:

For example, a Iirm supplies branded good 'Lux Soap' in the market. %here are many other Iirms in the
market which sell similar soaps (not identical) with diIIerent brand names like Rexona, Palm Rose, etc.,
etc. %he Iirm supplying 'Lux Soap' enjoys a monopoly position over the sale oI its own product. It also
Iaces competition Irom Iirms selling similar products.

Same is the case with many other Iirms in the market like plywood manuIacturing, jewellery making,
wood Iurniture, book stores, departmental stores, repair services oI all kinds, proIessional services oI
doctors, technicians, etc., etc. %hese Iirms and others which have an element oI monopoly power and also
Iace competition over the sale oI product or service in the market are called monopolistically competitive
Iirms.

Characteristics of Monopolistic/Imperfect Competition:

%he main characteristic or features of monopolistic competition are as under:

(i) A fairly large number of sellers: %he number oI Iirms in monopolistic competition is Iairly large.
Each Iirm produces or sells a close substitute Ior the product oI other Iirms in the product group or
industry. .Product diIIerentiation is thus the hallmark oI monopolistic competition.

(ii) Differentiation in products: Under monopolistic competition, the Iirms sell diIIerentiated products.
Product diIIerentiation may be real or imaginary. Real diIIerentiation is done through diIIerences in the
materials used, design, color etc. Imaginary diIIerences may be created through advertisement, brand
name, trade marks etc. %he Iirms producing similar products in .this imperIectly competitive world cannot
raise the price oI product much higher than their rivals. II they do so, they will lose much oI their sale, but
not all the sale. In case, they lower the price, the total sale can be increased to a certain extent. How much
will the sale increase or decrease by lowering or raising the price will depend upon the product
diIIerentiation oI the diIIerent Iirms.

II the product oI the various Iirms are very close substitutes oI one another and no imaginary or real
diIIerence exists in the mind oI the buyers, then a slight rise or Iall in the price oI the product oI one Iirm
will appreciably decrease or increase the demand Ior the product. II the product oI one Iirm diIIers Irom
that oI other Iirm, (though the diIIerence may be an imaginary one) a slight rise in the price oI the product
oI one Iirm will not drive away all its customers. A Iew Iaithless buyers may be attracted by the low price
oI the other rival product but not all the buyers.

(iii) Advertisement and propaganda: Another very important characteristic oI the monopolistic
competition is that each Iirm tries to create diIIerence in its product Irom the other by advertising,
propaganda, attractive packing, nice smile, etc., etc. When it succeeds in its object, the Iirm occupies
almost the position oI a monopolist. It is, thus, in a position to raise-the price oI the product without
losing its customers.

(iv) Nature of demand curve: Since the existence oI close substitutes limits the monopoly power, the
demand curve Iaced by a monopolistically competitive Iirm is Iairly elastic. %he precise degree oI
elasticity will however, depend upon the number oI Iirms in the group product or industry. II the number
oI Iirms is Iairly large and the product oI each Iirm is not very similar, the demand curve oI a Iirm will be
quite elastic. In case, there is close competition among the rival Iirms Ior the sale oI similar products, the
demand curve oI a Iirm will be less elastic.
(v) Freedom of entry and exit of firms: %he entry oI new Iirms in the monopolistically competition
industry is relatively easy. %here are no barriers oI the new Iirm to enter the product group or leave the
industry in the long run.

(vi) Sales efforts: With heterogeneous products, the sale oI the products by the Iirms can no longer be
taken Ior granted sale depends upon sale eIIorts.

(vii) Non-price competition: In monopolistic competition, the Iirms make every eIIort to win over the
customers. Other than price cutting, the Iirms may oIIer aIter sale service, a giIt scheme, discount not
declared in the price list etc.

Short Run Equilibrium Under Monopolistic/Imperfect Competition:

onopolistic competition reIers to the market organization where there are a Iairly large number oI Iirms
which sell somewhat diIIerentiated products.

A single Iirm in the product group (industry) has little impact on the market price. However, iI it reduces
price, it can expect a considerable increase in its sales. %he Iirm may also attract buyers away Irom other
Iirms by creating imaginary or real diIIerence through advertising, branding and through many other sales
promotion measures (non-price competition). II the Iirm raises its price, it will not lose all its customers.
%his is because oI the Iact that the product is diIIerentiated Irom competing Iirms due to price and non-
price Iactors. %he demand curve (AR curve) oI the monopolistic Iirm is thereIore, highly elastic and is
downward sloping. As regards the marginal revenue curve, it slopes downward and lies below the
demand curve because price is lowered oI all the units to sell more output in the market.

Firm's Equilibrium Price and Output:

In the short-run, the number oI Iirms in the 'product group' remains the same. %he size oI the plant oI each
Iirm remains unaltered. %he Iirm whether operating under perIect competition, or monopoly wants to
maximize proIits. In order to achieve this objective, it goes on producing a commodity so long as the
marginal revenue is greater than marginal cost. When R C, it is then in equilibrium and produces
the best level oI output. II a Iirm produces less than or more than the R C output, it will then not be
making maximum oI proIits.

In the short-run, a monopolistically competitive Iirm may be realizing abnormal proIits or suIIering
losses. II it is earning proIits, no new Iirms can enter the industry in the short-run. In case, it is suIIering,
losses but covering Iull variable cost, the Iirm will continue operating so that the losses are minimized. II
the Iull variable cost is not met, the Iirm will close down in the short-run. %he short-run equilibrium with
proIits and short run equilibrium with losses oI a monopolistically competitive Iirm are explained with the
help oI two separate diagrams as under.

Diagram:



In the Iigure (17.1), the downward sloping demand curve (AR curve) is quite elastic. %he R curve lies
below-the average curve except at point N. %he SC curve which includes advertising and sales
promotional costs is drawn in the usual Iashion. %he SC curve cuts the R curve Irom below at point
Z. %he Iirm produces and sells an output OK, as at this level oI output R C. %he Iirm sells output
OK at OE/K per unit price. %he total revenue oI the Iirm is equal to the area OEK, whereas the total
cost oI producing output OK is OFLK. %he total proIits oI the Iirm are equal to the shaded rectangle
FEL. %he Iirm earns abnormal proIits in the short run.

Short Run Losses:

II the demand and cost situations are not Iavorable in the market, a monopolistically competitive Iirm
may incur losses in the short-run. %he short-run equilibrium oI the Iirm with losses is explained with the
help oI a diagram.

Diagram:



In the Figure (17.2), marginal cost (SC) equates marginal revenue R curve Irom below at point Z.
%he Iirm produces output OK and sells at OF/K% per unit-price. %he total receipt oI the Iirm is OF%K.
%he total cost oI producing output OK is equal to OEK. %he Iirm suIIers a net loss equal to the area
FE% on the sale oI OK output.
Equilibrium Price and Output in the Long Run Under Monopolistic/Imperfect Competition:

Long Run Zero Economic Profits:

In the long run, the Iirms are able to alter the scale oI plant according to the changed conditions oI
demand Ior a product in the market. %hey can also leave or enter the industry. II the Iirms are earning
abnormal proIits in the short run, then new Iirm will enter the 'product group' (industry). %he tendency oI
the new Iirms to enter the industry continues till the abnormal proIits are competed away and the Iirms
economic proIits are zero. In case the monopolistically competitive Iirms realize losses in the short-run,
then some oI the Iirms will leave the industry. %he exit oI the Iirm continues till zero economic proIits are
restored with the operating Iirms.
In the long-run, there are no entry barriers Ior the new Iirms. %he incoming Iirms install latest machinery
and try to diIIerentiate their products Irom those oI the established Iirms. %he old Iirms operating with
.the used machinery try to match up with the new entrants by improved variety oI products in their group.
%hey increase expenditure on advertisement and on other sales promotional measures. %hey employ more
qualiIied staII Ior. making technical improvement in their products. Since all the Iirms Ior their existence
incur additional expenditure Ior improving the quality oI the products, the cost curves oI all the Iirms
move up. Due to entry oI new Iirms in the industry and higher costs oI production, the output oI each
competing Iirm is reduced. %here is, thereIore, a waste in the economic resources oI the country. %he
equilibrium price and output in the long-run is explained with the help oI a diagram.

Diagram:



In the Iigure (17.3), the higher shiIted long-run marginal cost curve intersects the higher shiIted marginal
revenue curve at point . %he Iirm at this raised equilibrium point, produces the reduced level oI output
OK. It sells this output at price %K as at point %, LAC is a tangent to the demand or average revenue
curve at its minimum point. %he total revenue oI the Iirm is equal to the area OE%K. %he total costs oI the
Iirm are also equal to the area OE%K. %he Iirm is earning only zero or normal economic proIits. As the
monopolistically competitive Iirm sets a price higher than that minimum average cost in the long-run,
the firm therefore produces a smaller output. Since all the Iirms in the product group produce less at
higher price, there is, thereIore, an apparent waste oI resources and exploitation oI the consumers.
%he advocates oI monopolistic competition are oI the opinion that iI consumers get diIIerentiated
products at slightly higher prices (than with no choice under perIect competition), the consumers are then
not exploited. %here is no wasting oI resources either, as the consumer's welIare increases with the
product diIIerentiation.
Wastes of Monopolistic/Imperfect Competition:

Under monopolistic competition or imperIect competition, there are wastes oI expenditures. Wastes of
monopolistic competition are in brieI as Iollows:

(i) Huge expenditure on advertisement: %he entrepreneurs in order to overcome the irrational
preIerences oI the consumers like prejudices, liking oI commodities, or shop or person have to spend
large sums oI money on advertisements. %his is purely a waste Irom community point oI view.

(ii) Expenditure on cross transportation: Another waste oI monopolistic competition is the expenditure
incurred on the cross transportation oI the commodity. For instance, iI a commodity produced in New
York is very similar to the commodity produced in Washington, the buyers in Washington due to their
irrational preIerences may demand the commodity produced in New York and vice versa Had the buyers
given preIerence to the commodity produced in their own locality, this would have saved the expenditure
on cross transportation oI the goods.

(iii) Production of variety of products: Under monopolistic competition, an industry may not specialize
in the production oI those commodities Ior which it is best Iitted. %his is because oI Iact that it has to
spend large sum oI money on advertisement and secondly it has to cut down the prices in order to attract
the customers. So it may Iind advantageous "to produce varied assortment oI types and qualities to sell to
its own particular customers rather than Iace the cost oI attracting a large number oI customers Ior one
type oI product alone".

(iv) Existence of inefficient firms: Under monopolistic competition, the ineIIicient Iirms also continue
producing the commodities along with the eIIicient Iirms due to irrational preIerences oI the customers.
%he customers, thereIore, have to pay higher prices Ior the goods produced by the ineIIicient Iirm. %he
consumers, thus, suIIer monetary loss and the nation wastage oI resources.
(v) Prevents standardization of products: Another wastage oI imperIect competition is that it prevents
!he standardization oI the commodities. When goods are standardized, they can be produced on a large
scale. In case oI monopolistic competition or imperIect competition, no producer would like to produce
any design oI the commodity on a large scale because it involves risk. %he liking oI the design may
change and his goods remain-unsold.

(vi) A firm need not be of the optimum size: Under perIect competition, all the Iirms in the long run are
oI optimum size and they are producing at the lowest average cost. II a Iirm is not oI most eIIicient size, it
will have to expand its output so that it should produce at minimum average cost. Under monopolistic
competition, a Iirm need not be oI the optimum size. %here is no doubt that iI it expands its output, the
average cost will Iall but then it will have to lower the price as well. %he reduction in price may result in
decrease oI total revenue. So the Iirm may not expand its scale oI business. From this, we conclude, that
the total number oI Iirms in an industry, under monopolistic competition, will be greater than under
perIect competition. %his is due to the Iact that in perIect competition all the Iirms are, oI the most
eIIicient size and ineIIicient Iirms are eliminated. While in monopolistic competition, ineIIicient Iirms
along with eIIicient Iirms continue to exist. %he society, thus, pays higher prices Ior the products.

Price and Output Determination Under Oligopoly:

Definition of Oligopoly:

Oligopoly Ialls between two extreme market structures, perIect competition and monopoly. ligopoly
occurs when a Iew Iirms dominate the market Ior a good or service. %his implies that when there are a
small number oI competing Iirms, their marketing decisions exhibit strong mutual interdependence. By
mutual interdependence we mean that a Iirm's action say oI setting the price has a noticeable eIIect on its
rival Iirms and they are likely to react in the some way. Each Iirm considers the possible reaction oI rivals
to its price and product development decisions.

Stigler Hads deIined oligopoly:

"As that market situation in which a Iirm bases its market policy in part on the expected behaviour oI a
Iew close rival Iirms".

In the words oI 1ackson:

"Oligopoly is an industry structure characterized by a Iew Iirms producing all or most oI the output oI
some good that may or may not be diIIerentiated".

%he term a few firms covers two to ten Iirms dominating the entire market Ior a good. II there are only
two Iirms in the market, the oligopoly is called Duopoly.

%he analysis oI duopoly raises all those problems which are conIronted while explaining oligopoly with
more than two rival Iirms. any industries including cement, steel, automobiles, mobile phones, cigrates,
beverages etc.; are oligopolistic.

Oligopolies may be homogeneous or diIIerentiated. II Iirms in an oligopolistic industry produce
standardized products like petroleum product, aluminum, rubber products, the industry is said to be
producing under oligopolistic conditions. On the other hand, iI the Iirms are producing goods, which are
close substitutes Ior each other, then diIIerentiate oligopoly is said to prevail. utual interdependence is
greater when products are identical and it is lesser when goods are diIIerentiated.

Explanation of Price and Output Determination Under Oligopoly:

%here is not a single theory which satisIactorily explains the pricing and output decisions under duopoly.
%he reasons are:

(i) %he number oI Iirms, dominating the market vary. Sometimes there are only two or three Iirms which
dominate the entire market (%ight oligopoly). At another time there may be 7 to 10 Iirms which capture
80 oI the market (loose oligopoly).

(ii) %he goods produced under oligopoly may or may not be standardized.

(iii) %he Iirms under oligopoly sometime cooperate with each other in the Iixing oI price and output oI
goods. At another time, they preIer to act independently.

(iv) %here are situations also where barriers to entry are very strong in oligopoly and at another time, they
are quite loose.

(v) A Iirm under oligopoly cannot predict with certainly the reaction oI the rival Iirms, iI it increases or
decreases the prices and output oI its goods. Keeping in view the wide range oI diversity oI market
situations, a number oI models have been developed explaining the behaviour oI the oligopolistic Iirms.

Causes of Oligopoly:

%he main reasons which give rise to oligopoly are as Iollows:

(i) Economies of scale: II the productive capacity oI a Iew Iirms is large and are able to capture a greater
percentage oI the total available demand Ior the product in the market, there will then be a small number
oI Iirms in an Industry. %he Iirms in the industry with heavy investment, using improved technology and
reaping economies oI scale in production, sales, promotion, etc., will compete and stay in the market. %he
Iirms using outdated machinery and old techniques oI production will not be able to compete with the low
unit costs producing Iirms and eventually wipe out Irom the industry. Oligopoly is, thus, promoted due to
the economies oI scale.

(ii) Barriers to entry: In many oligopolies, the new Iirms cannot enter the industry as the big Iirms have
ownership oI patents or control over the essential raw material used in the production oI an output. %he
heavy expenditure on advertising by the oligopolistic industries may also be a Iinancial barrier Ior the
new Iirms to enter the industry.

(iii) Merger: II the Iew Iirms in the industry smell the danger oI entry oI new Iirms, they then
immediately merge and Iormulate a joint policy in the pricing and production oI the products.
%he joint action oI a Iew big Iirms discourage the entry oI new Iirms into the industry.

(iv) Mutual interdependence: As the number oI Iirms is small in an
oligopolistic industry, thereIore, they keep a strict watch oI the price charged by rival Iirms in the
industry. %he Iirm generally avoid price war and try to create conditions oI mutual interdependence.

Characteristics of Oligopoly:

%he main characteristics of oligopoly are as Iollows:

(i) Small number of firms: Oligopoly is a market structure characterized by a Iew Iirms. %hese handIul
oI Iirms dominate the industry to set prices.

ii] Interdependence: All Iirms in an industry are mostly interdependent. Any action on the part oI one
Iirm with respect to output, quality product diIIerentiation can cause a reaction on the part oI other Iirms.

(iii) Realization of profit: Oligopolists Iirms are oIten thought to realize economic proIits. Whenever
there are proIits, there is incentive Ior entry oI new Iirms. %he existing Iirms then try to obstruct entry oI
new Iirms into the industry.

(iv) Strategic game: In an oligopolistic market structure, the entrepreneurs oI the Iirms are like generals
in a war. %hey attempt to predict the reactions oI rival Iirms. It is a strategy game which they play.

Pricing and Output Determination Under Duopoly:

Definition and Explanation:

II an industry is composed oI only two giant Iirms, each selling identical products and having halI oI the
total market, there is every likelihood oI collusion between the two Iirms. %he Iirms may agree on a price,
or divide the market, or assign quota, or merge themselves into one unit and Iorm a monopoly or try to
diIIerentiate their products or accept the price Iixed by the leader Iirm, etc., etc.

In case the duopolists producing perIect substitute engage in price competition, the Iirm having lower
costs, better goodwill and clientele will drive the rival Iirm out oI the market and then establish a
monopoly.

II the products oI the duopolists are diIIerentiate, each Iirm will have a close watch on the actions oI its
rival Iirms. %he Iirms manuIacturing good quality products with lesser cost will earn abnormal proIits.
Each Iirm will Iix the price oI the commodity and expand output in accordance with the demand oI the
commodity in the market.

Duopoly Models:

%here are Iour main duopoly models which explain the price and quantity determinations in duopoly.
%hese models are:

(i) Classical odel oI Cournot and Edge Worth.
(ii) Hotellings Spatial Equilibrium odel.
(iii) Stackelberg's odel.
(iv) odern Game %heory odel.

A very brieI explanation oI these is given below:

(i) Cournot and Edgeworth Model:

Cournot approach is based, on the assumptions that rivals output remains the same and one duopolists
plans to change in his output. Edgeworth model assumes that rival's price oI the good to remain
unchanged as one duopolists plans a change in his price oI the good.

(ii) Stackberg's Approach:

It is based on the assumptions that one oI the duopolists is a 'Leader' and the other is the Iollower.

(iii) Hotelling Spatial Equilibrium Model:

In this model, the products oI the duopolists are diIIerentiate in the eyes oI the buyers by virtue oI the
location oI the duopolists.

(iv) The Game Theory Approach:

Whenever there are two or a Iew Iirms competing in an industry Ior proIit, each Iirm can and dose react to
the price, quantity, quality and product changes which other Iirm undertakes. %he duopolists or oligopoly
have a reaction Iunction. As Iirms under duopoly are independent, they, thereIore, employ strategies. %he
competing Iirm also make plans to contract and makes decisions about output and price oI the good
keeping in view the strategy oI its rivals. %he plans made by these Iirm, are known as game strategies.
%he game theory model describes the Iirms, interaction model. It is the analytical Iramework in which
two or more Iirms compete Ior economics proIits that depend on the strategy that the others employ.

All games theory models have at least three common elements:

(a) Players: Players in the game theory are the Iirms.

(b) Strategies: Strategies are the plans, the possible choices oI the Iirms Ior production oI output, prices oI
goods, changes in the quality oI the product
.
(c) Pay oIIs (economic proIit): %hese are the proIits or losses realized by the Iirm.

Three Important Models of Oligopoly:

%hree mportant Economic Models of ligopoly are as:

(1) Price and output determination under collusive oligopoly.
(2) Price and output determination under non-collusive oligopoly.
(3) Price leadership model.

(1) Price and Output Determination Under Collusive Oligopoly:

%he term collusion implies to 'play together'. When Iirms under oligopoly agree Iormally not to compete
with each other about price or output, it is called collusive oligopoly. %he Iirms may agree on setting
output quota, or Iix prices or limit product promotion or agree not to 'poach' in each other's market. %he
completing Iirms thus Irom a 'cartel'. %he members oI Iirms behave as iI they are a single Iirm.

Assumptions of Price and Output Determination Under Collusive Oligopoly:

For price output determination in a collusive oligopoly, we assume that (i) there are only three Iirms in
the industry and they Iorm a cartel, (ii) the products oI all the three Iirms are homogenous (iii) the cost
curves oI these Iirms are identical.

Under the assumptions stated above, the equilibrium oI the industry under collusive oligopoly is
explained with the help oI a diagram.

Diagram:



In this Iigure 17.4, the industry demand curve DD consisting oI three Iirms is identical. So is the case
with the R curve and C curve which are identical. %he cartel's R curve intersects the C curve at
point L. ProIits are maximized at output OQ
1
, where C R. %he cartel will set a price OP
1
, at which
OQ
1
, output will be demanded.

Having agreed on the cartel price, the members may then complete each other using non price
competition to gain as big share oI resulting sales OQ
1
as they can.

%here is another alternative also. %he cartel members may agree to divide the market between them. Each
member would given a quota. %he sum oI all the quotas must add up to Q
1
. In case the quotas exceeded
OQ
1
either the output will remain unsold at OP price or the price would Iall.

(2) Price and Output Determination Under Non-Collusive Oligopoly:

It will be explain with the help oI kinked Demand Curve odel.

(i) The Kinked Demand Curve Model:

%he inked demand curve model was developed by Paul Sweezy (1939). According to him, the Iirms
under oligopoly try to avoid any activity which could lead to price wars among them. %he Iirms mostly
make eIIorts to operate in non price competition Ior increasing their respective shares oI the market and
their proIit. An analytical device which is used to explain the oligopolistic price rigidity is the Kinked
Demand Curve.

%his model operates on IulIilling certain conditions which, in brieI, are as under:

(a) All the Iirms in the industry are quite developed with or without product diIIerentiation.

b} All the Iirms are selling the goods on Iairly satisIactory price in the market.

(c) II any one Iirm lowers the price oI its product to capture a larger share oI the market, the other Iirms
Iollow and reduce the price oI their goods in order to retain their share oI the market.

(d) II one Iirm raises the price oI its goods, the other Iirms will not Iollow the price increase. Some oI the
customers oI the price raising Iirm will shiIt to the relatively low priced Iirms.

r. Paul Sweezy used two demand curve concepts to explain the model. %hese are reproduced below:

Diagram:



In the Iigure 17.5. DD
/
is a kinked demand curve. It is made up or two segments DB and BD
/
. %he
demand curve is kinked Or has a bend at point B. %he kink is Iormed at the prevailing market price level
B ($10 per unit). %he segment oI the demand curve above the prevailing price level ($10) is highly
elastic and the segment oI the demand curve below the prevailing price level is Iairly inelastic. %his is
explained now in brieI.

Explanation:

Price increase. II an oligopolistic raises the price oI his products Irom $10 per unit to $12 per unit, he
loses a large part oI the market and his sale comes down to 40 units Irom 120 units. %here is a loss oI 80
units in sale as most oI his customers are now purchasing goods Irom his competitor Iirms who are selling
the goods at $10 per units. So an increase in price above the prevailing level-shows that the demand curve
to the leIt oI and above point B is Iairly elastic.

Price reduction. II an oligopolistic reduces the prices oI its goods below the prevailing price level B
($10 per unit) Ior increasing his sales, his competitors will also match price changes so that their
customers do not go away Irom them. Let us assume that Oligopolist has lowered the price to $4.0 per
unit. Its competitors in the industry match the price cut. %he sale oI the oligopolist with a big price cut oI
$.6.0 per unit has increased by only 40 units (160 - 120 40). %he Iirm does not gain as the total revenue
decreases with the price cut. %he BD
/
portion oI the demand curve which lies on the right side and below
point B is Iairly inelastic.

Rigid Prices. %he Iirms in the oligopolist market 'have no incentive to raise or lower the prices oI the
goods. %hey preIer to sell the goods at the prevailing price level due to reaction Iunction. %he price B
($10 per unit) will, thereIore, tend to remain stable or rigid, as every member oI the oligopoly does not
see any gain by lowering or raising the price oI his goods.

(3) Price Leadership Model:

%he Iirms in the oligopolistic market are not happy with price competition among themselves. %hey try
various methods to maximize joint proIits. Price leadership is one oI the means which provides relieI to
the Iirms Irom the strains oI price competition.

%he Iirms in the oligopolistic industry (without any Iormal agreement) accept the price set by the leading
Iirm in the industry and move their prices in line with the prices oI the leader Iirm. %he acceptance oI
price set by the price leader Iirm maximizes the total proIits oI each Iirm in the oligopolistic industry.

Assumptions:

%he main assumptions of price leadership model under oligopoly are as under:

(a) %here are two Iirms A and B in the market.
(b) %he output produced by the two Iirms is homogeneous.
(c) %he Iirm 'A being the low cost Iirm or a dominant Iirm acts as a leader Iirm.
(d) Both oI the Iirms Iace the same demand curve.
(e) Each oI the two Iirms has an equal share in the market. %he price and output determination under
price leadership is now explained with the help oI the diagram below.

Diagram:



In this Iigure 1 7.6, DD
/
is the demand curve which is Iaced by each oI the two Iirms. R is the marginal
revenue curve oI each Iirm. Ca is the marginal cost oI Iirm A and C
b
is the marginal cost oI Iirm B.
We have assumed that the Iirm A is a low cost Iirm than Iirm B. As such the Ca lies below C
b
.

%he leader Iirm using the marginalistic rule oI C R is in equilibrium at point E. %he Iirm A
maximizes proIits by selling output O and setting price P. %he Iirm B is in equilibrium at point F
where C
b
R.

%he Iirm B maximizes proIits by producing ON output and selling it at NK price. %he
Iirm B has to compete Iirm A in the market, iI the Iirm B Iixes the price NK per unit, it will not be able to
compete with Iirm A which is selling goods at P price per unit.

Hence, the Iirm B will be compelled to Iollow the leader Iirm A. %he Iirm B will also charge P price
per unit as set by the Iirm A. %he Iirm B will also produce Q output like the Iirm A. %hus both the Iirms
will charge the same price P and sell each oI them O output. %he total output will thus be twice oI
O.
%he Iirm A being the low cost Iirm will maximize proIits by selling O output at P price. %he proIits
oI the Iirm B is lower than oI Iirm A because its costs oI production is higher than oI Iirm A.

Conclusion:

AIter studying the pricing and output decisions under various Iorms oI oligopoly, the main conclusion
drawn is that allocate and productive eIIiciency are unlikely to be achieved under them. However,
Schumpeters view Is that oligopolists have both the Incentive and Iinancial and technical resources to be
more technological progressive than competitive Iirms.

Introduction to Theory of Factor Pricing OR Theory of Distribution:
Definition and Explanation of Theory of Factor Pricing:

%he theory of distribution or the theory of factor pricing deals with the determination oI the share prices
oI Iour Iactors oI production, viz., land, labor, capital and organization.

Four Factors of Production, in Economics:

(i) %he share oI land, is named as Rent.
(ii) %he share oI labor as Wages.
(iii) %he share oI capital as Interest.
(iv) %he share oI organization as ProIit.

%he four factors of production in cooperation with one another produce annually a net aggregate oI
commodities, material and non-material. %his we name as national income. %he national income is to be
shared among the Iour Iactors oI production which have contributed to this production. In the theory of
distribution, we are chieIly concerned wrath the principles according to which the price oI each Iactor oI
production is determined and distributed.

In the words oI Chapman: "%he Economics of distribution or the pricing of factors accounts Ior the
sharing oI the wealth produced by a community among the agents or the owners oI the agents which have
been active in its production".

Distribution is Functional and not Personal. I would like to make it clear that the pricing oI Iactor oI
production discussed here is Iunctional and not personal. By this we mean that when the reward oI each
Iactor is distributed, it is not paid to an individual but to the agents or Iactors oI production. %he
individual may represent in his person as landlord (iI he used his own land), the labor (iI he works
himselI), the capitalist (iI he has contributed his capital) and. the entrepreneur (iI be organizes the
business). %he price oI land, labor, capital and organization which is termed as rent, wages, interest and
proIit is in Iact their Iunctional income. %hey are the costs Irom the point oI view oI the Iirm but income
Irom the point oI view oI Iactors oI production.

Why a Separate Theory of Factor Pricing?

It is oIten pointed out that the price oI a Iactor oI production is determined, like the price oI a commodity,
by the equilibrium oI Iorces oI demand and supply, II the demand oI the particular Iactor rises, other
things remaining the same, its price goes up and vice versa %he other economists who diIIer with this
view are oI the opinion that the theory oI value is not applicable in its entirety to the pricing oI Iactor oI
production. %hey believe that on the side oI demand there is similarity between the two, because the value
oI a particular commodity and the price oI a Iactor oI production are governed by marginal utility and
marginal productivity respectively. But on the side oI supply, much diIIerence exists between them. On
the side oI supply, the price oI a particular commodity is determined by its marginal cost oI production.
But in ease oI labor or an acre oI land or a unit capital, it is not possible to ascertain exactly its costs oI
production. %he other dissimilarity between the two is that the supply oI a Iactor oI production cannot be
readily adjusted as we can do in the case oI a commodity. For example, iI the demand oI a particular type
oI labor increases or the rent oI land rises-up, it will not be possible to increase their supply immediately.

In the words oI Marshall: "Free human beings are not brought up to their work on the same principle oI a
machine, a house oI a slave. II they were, there would he very little diIIerence between the distribution
and the exchange side oI value".

%hus, we come to the conclusion that though the value oI the commodities and the prices oI the Iactors oI
production are determined by demand and supply yet, due to some diIIerences oI the Iactors oI production
on the side oI supply, there is a need Ior a separate theory oI distribution.
MONOPOLY AND PERFECT COMPETITION:
onopoly and perIect competition represent two extremes along a continuum oI market structures. At the
one extreme is perIect competition, representing the ultimate oI eIIiciency achieved by an industry that
has extensive competition and no market control. onopoly, at the other extreme, represents the ultimate
oI ineIIiciency brought about by the total lack oI competition and extensive market control.
onopoly is a market structure with complete market control. As the only seller in the market, a
monopoly controls the supply-side oI the market. PerIect competition, in contrast, is a market structure in
which each Iirm has absolutely no market control. No Iirm in perIect competition can inIluence the
market price in any way.
%he best way to compare monopoly and perIect competition is the Iour characteristics oI perIect
competition: (1) large number oI relatively small Iirms, (2) identical product, (3) Ireedom oI entry and
exit, and (4) perIect knowledge.
O Number oI Firms: PerIect competition is an industry comprised oI a large number oI small Iirms,
each oI which is a price taker with no market control. onopoly is an industry comprised oI a
single Iirm, which is a price maker with total market control.
O Available Substitutes: Every Iirm in a perIectly competitive industry produces exactly the same
product as every other Iirm. An inIinite number oI perIect substitutes are available. A monopoly
Iirm produces a unique product that has no close substitutes and is unlike any other product.
O Resource obility: PerIectly competitive Iirms have complete Ireedom to enter the industry or
exit the industry. %here are no barriers. A monopoly Iirm oIten achieves monopoly status because
the entry oI potential competitors is prevented.
O InIormation: Each Iirm in a perIectly competitive industry possesses the same inIormation about
prices and production techniques as every other Iirm. A monopoly Iirm, in contrast, oIten has
inIormation unknown to others.
UNIT V
Measures of national income and output
A variety oI measures of national income and output are used in economics to estimate total economic
activity in a country or region, including gross domestic product (GDP), gross national product (GNP),
and net national income (NNI). All are especially concerned with counting the total amount oI goods and
services produced within some "boundary". %he boundary is usually deIined by geography or citizenship,
and may also restrict the goods and services that are counted. For instance, some measures count only
goods and services that are exchanged Ior money, excluding bartered goods, while other measures may
attempt to include bartered goods by imputing monetary values to them.
Contents
1 National accounts
2 arket value
a. %he output approach
b. %he income approach
c. %he expenditure approach
3 DeIinitions
4 GDP and GNP
5 National income and welIare
1 DiIIiculties in easurement oI National Income
a. Conceptual DiIIiculties
b. Practical DiIIiculties
National accounts
Arriving at a Iigure Ior the total production oI goods and services in a large region like a country entails a
large amount oI data-collection and calculation. Although some attempts were made to estimate national
incomes as long ago as the 17th century,
|2|
the systematic keeping oI national accounts, oI which these
Iigures are a part, only began in the 1930s, in the United States and some European countries. %he
impetus Ior that major statistical eIIort was the Great Depression and the rise oI Keynesian economics,
which prescribed a greater role Ior the government in managing an economy, and made it necessary Ior
governments to obtain accurate inIormation so that their interventions into the economy could proceed as
much as possible Irom a basis oI Iact.
Market value
In order to count a good or service it is necessary to assign some value to it. %he value that the measures
oI national income and output assign to a good or service is its market value the price it Ietches when
bought or sold. %he actual useIulness oI a product (its use-value) is not measured assuming the use-
value to be any diIIerent Irom its market value.
%hree strategies have been used to obtain the market values oI all the goods and services produced: the
product (or output) method, the expenditure method, and the income method. %he product method looks
at the economy on an industry-by-industry basis. %he total output oI the economy is the sum oI the
outputs oI every industry. However, since an output oI one industry may be used by another industry and
become part oI the output oI that second industry, to avoid counting the item twice we use not the value
output by each industry, but the value-added; that is, the diIIerence between the value oI what it puts out
and what it takes in. %he total value produced by the economy is the sum oI the values-added by every
industry.
%he expenditure method is based on the idea that all products are bought by somebody or some
organisation. %hereIore we sum up the total amount oI money people and organisations spend in buying
things. %his amount must equal the value oI everything produced. Usually expenditures by private
individuals, expenditures by businesses, and expenditures by government are calculated separately and
then summed to give the total expenditure. Also, a correction term must be introduced to account Ior
imports and exports outside the boundary.
%he income method works by summing the incomes oI all producers within the boundary. Since what
they are paid is just the market value oI their product, their total income must be the total value oI the
product. Wages, proprieter's incomes, and corporate proIits are the major subdivisions oI income.
The output approach
%he output approach Iocuses on Iinding the total output oI a nation by directly Iinding the total value oI
all goods and services a nation produces.
Because oI the complication oI the multiple stages in the production oI a good or service, only the Iinal
value oI a good or service is included in total output. %his avoids an issue oIten called 'double counting',
wherein the total value oI a good is included several times in national output, by counting it repeatedly in
several stages oI production. In the example oI meat production, the value oI the good Irom the Iarm may
be $10, then $30 Irom the butchers, and then $60 Irom the supermarket. %he value that should be included
in Iinal national output should be $60, not the sum oI all those numbers, $100. %he values added at each
stage oI production over the previous stage are respectively $10, $20, and $30. %heir sum gives an
alternative way oI calculating the value oI Iinal output.
Formulae:
GDP (gross domestic product) at market price value oI output in an economy in a particular year -
intermediate consumption
NNP at Iactor cost GDP at market price - depreciation NFIA (net factor income from abroad - net
indirect taxes
The income approach
%he income approach equates the total output oI a nation to the total Iactor income received by residents
or citizens oI the nation. %he main types oI Iactor income are:
O Employee compensation ( wages cost oI Iringe beneIits, including unemployment, health, and
retirement beneIits);
O Interest received net oI interest paid;
O Rental income (mainly Ior the use oI real estate) net oI expenses oI landlords;
O Royalties paid Ior the use oI intellectual property and extractable natural resources.
All remaining value added generated by Iirms is called the residual or proIit. II a Iirm has stockholders,
they own the residual, some oI which they receive as dividends. ProIit includes the income oI the
entrepreneur - the businessman who combines Iactor inputs to produce a good or service.
Formulae:
NDP at Iactor cost Compensation oI employees Net interest Rental & royalty income ProIit oI
incorporated and unincorporated Iirms Income Irom selI-employment.
National income NDP at Iactor cost NFIA (net Iactor income Irom abroad).
The expenditure approach
%he expenditure approach is basically an output accounting method. It Iocuses on Iinding the total output
oI a nation by Iinding the total amount oI money spent. %his is acceptable, because like income, the total
value oI all goods is equal to the total amount oI money spent on goods. %he basic Iormula Ior domestic
output combines all the diIIerent areas in which money is spent within the region, and then combining
them to Iind the total output.
Where:
C household consumption expenditures / personal consumption expenditures
I gross private domestic investment
G government consumption and gross investment expenditures
X gross exports oI goods and services
M gross imports oI goods and services
Note: (X - M) is oIten written as X
N
, which stands Ior "net exports"
Definitions
%he names oI the measures consist oI one oI the words "Gross" or "Net", Iollowed by one oI the words
"National" or "Domestic", Iollowed by one oI the words "Product", "Income", or "Expenditure". All oI
these terms can be explained separately.
"Gross" means total product, regardless oI the use to which it is subsequently put.
"Net" means "Gross" minus the amount that must be used to oIIset depreciation ie., wear-and-
tear or obsolescence oI the nation's Iixed capital assets. "Net" gives an indication oI how much
product is actually available Ior consumption or new investment.
"Domestic" means the boundary is geographical: we are counting all goods and services
produced within the country's borders, regardless oI by whom.
"National" means the boundary is deIined by citizenship (nationality). We count all
goods and services produced by the nationals oI the country (or businesses owned by
them) regardless oI where that production physically takes place.
%he output oI a French-owned cotton Iactory in Senegal counts as part oI the Domestic
Iigures Ior Senegal, but the National Iigures oI France.
"Product", "Income", and "Expenditure" reIer to the three counting methodologies
explained earlier: the product, income, and expenditure approaches. However the terms
are used loosely.
"Product" is the general term, oIten used when any oI the three approaches was actually
used. Sometimes the word "Product" is used and then some additional symbol or phrase
to indicate the methodology; so, Ior instance, we get "Gross Domestic Product by
income", "GDP (income)", "GDP(I)", and similar constructions.
"Income" speciIically means that the income approach was used.
"Expenditure" speciIically means that the expenditure approach was used.
Note that all three counting methods should in theory give the same Iinal Iigure. However, in practice
minor diIIerences are obtained Irom the three methods Ior several reasons, including changes in
inventory levels and errors in the statistics. One problem Ior instance is that goods in inventory have
been produced (thereIore included in Product), but not yet sold (thereIore not yet included in
Expenditure). Similar timing issues can also cause a slight discrepancy between the value oI goods
produced (Product) and the payments to the Iactors that produced the goods (Income), particularly iI
inputs are purchased on credit, and also because wages are collected oIten aIter a period oI production.

GDP and GNP
Gross domestic product (GDP) is deIined as "the value oI all Iinal goods and services produced in a
country in 1 year".
Gross National Product (GNP) is deIined as "the market value oI all goods and services produced in one
year by labour and property supplied by the residents oI a country."
As an example, the table below shows some GDP and GNP, and NNI data Ior the United States:
National income and output (Billions of dollars)

Period Ending 2003
Gross national product 11,063.3
Net U.S. income receipts Irom rest oI the world 55.2
NDP:
Net
domest
ic
produc
t is
deIined
as
"gross
domestic product (GDP) minus depreciation oI capital",
GDP per capita: Gross domestic product per capita is the mean value oI the output produced per person,
which is also the mean income.
National income and welfare
GDP per capita (per person) is oIten used as a measure oI a person's welIare. Countries with higher GDP
may be more likely to also score highly on other measures oI welIare, such as liIe expectancy. However,
there are serious limitations to the useIulness oI GDP as a measure oI welIare:
O easures oI GDP typically exclude unpaid economic activity, most importantly domestic work
such as childcare. %his leads to distortions; Ior example, a paid nanny's income contributes to GDP, but
an unpaid parent's time spent caring Ior children will not, even though they are both carrying out the
same economic activity.
O GDP takes no account oI the inputs used to produce the output. For example, iI everyone worked
Ior twice the number oI hours, then GDP might roughly double, but this does not necessarily mean that
workers are better oII as they would have less leisure time. Similarly, the impact oI economic activity on
the environment is not measured in calculating GDP.
O Comparison oI GDP Irom one country to another may be distorted by movements in exchange
rates. easuring national income at purchasing power parity may overcome this problem at the risk oI
overvaluing basic goods and services, Ior example subsistence Iarming.
O GDP does not measure Iactors that aIIect quality oI liIe, such as the quality oI the environment
(as distinct Irom the input value) and security Irom crime. %his leads to distortions - Ior example,
spending on cleaning up an oil spill is included in GDP, but the negative impact oI the spill on well-
being (e.g. loss oI clean beaches) is not measured.
O GDP is the mean (average) wealth rather than median (middle-point) wealth. Countries with a
skewed income distribution may have a relatively high per-capita GDP while the majority oI its citizens
U.S. income receipts 329.1
U.S. income payments -273.9
Gross domestic product 11,008.1
Private consumption oI Iixed capital 1,135.9
Government consumption oI Iixed capital 218.1
Statistical discrepancy 25.6
National Income 9,679.7
have a relatively low level oI income, due to concentration oI wealth in the hands oI a small Iraction oI
the population.
O Because oI this, other measures oI welIare such as the Human Development Index (HDI), Index
oI Sustainable Economic WelIare (ISEW), Genuine Progress Indicator (GPI), gross national happiness
(GNH), and sustainable national income (SNI) are used.
Difficulties in Measurement of National Income
%here are many diIIiculties when it comes to measuring national income, however these can be grouped
into conceptual diIIiculties and practical diIIiculties.
Conceptual Difficulties
O Inclusion oI Services: %here has been some debate about whether to include services in the
counting oI national income, and iI it counts as output. arxian economists are oI the belieI that services
should be excluded Irom national income, most other economists though are in agreement that services
should be included.
O IdentiIying Intermediate Goods: %he basic concept oI national income is to only include Iinal
goods, intermediate goods are never included, but in reality it is very hard to draw a clear cut line as to
what intermediate goods are. any goods can be justiIied as intermediate as well as Iinal goods
depending on their use.
O IdentiIying Factor Incomes: Separating Iactor incomes and non Iactor incomes is also a huge
problem. Factor incomes are those paid in exchange Ior Iactor services like wages, rent, interest etc. Non
Iactor are sale oI shares selling old cars property etc., but these are made to look like Iactor incomes and
hence are mistakenly included in national income.
O Services oI Housewives and other similar services: National income includes those goods and
services Ior which payment has been made, but there are scores oI jobs, Ior which money as such is not
paid, also there are jobs which people do themselves like maintain the gardens etc., so iI they hired
someone else to do this Ior them , then national income would increase, the argument then is why are
these acts not accounted Ior now, but the bigger issue would be how to keep a track oI these activities
and include the in national income.
Practical Difficulties
O Unreported Illegal Income: Sometimes, people don't provide all the right inIormation about their
incomes to evade taxes so this obviously causes disparities in the counting oI national income.
O Non onetized Sector: In many developing nations, there is this issue that goods and services are
traded through barter, i.e. without any money. Such goods and services should be included in accounting
oI national income, but the absence oI data makes this inclusion very diIIicult.
Government Intervention in the Market

In a free market economic system, scarce resources are allocated through the price mechanism
where the preIerences and spending decisions oI consumers and the supply decisions oI businesses
come together to determine equilibrium prices. %he Iree market works through price signals. When
demand is high, the potential proIit Irom supplying to a market rises, leading to an expansion in
supply (output) to meet rising demand Irom consumers. Day to day, the Iree market mechanism
remains a tremendously powerIul device Ior determining how resources are allocated among
competing ends.
Intervention in the market
%he government may choose to intervene in the price mechanism largely on the grounds oI wanting
to change the allocation oI resources and achieve what they perceive to be an improvement in
economic and social welIare. All governments oI every political persuasion intervene in the
economy to inIluence the allocation oI scarce resources among competing uses
What are the main reasons for government intervention?
%he main reasons Ior policy intervention are:
O %o correct Ior market failure
O %o achieve a more equitable distribution of income and wealth
O %o improve the performance of the economy
Options for government intervention in markets
%here are many ways in which intervention can take place some examples are given below
Government Legislation and Regulation
Parliament can pass laws that Ior example prohibit the sale oI cigarettes to children, or ban smoking
in the workplace. %he laws oI competition policy act against examples oI price-Iixing cartels or
other Iorms oI anti-competitive behaviour by Iirms within markets. Employment laws may oIIer
some legal protection Ior workers by setting maximum working hours or by providing a price-Iloor
in the labour market through the setting oI a minimum wage.
%he economy operates with a huge and growing amount oI regulation. %he government appointed
regulators who can impose price controls in most oI the main utilities such as telecommunications,
electricity, gas and rail transport. Free market economists criticize the scale oI regulation in the
economy arguing that it creates an unnecessary burden oI costs Ior businesses with a huge amount
oI red tape damaging the competitiveness oI businesses.
Regulation may be used to introduce fresh competition into a market Ior example breaking up the
existing monopoly power oI a service provider. A good example oI this is the attempt to introduce
more competition Ior British %elecom. %his is known as market liberalisation.
Direct State Provision of Goods and Services
Because oI privatization, the state-owned sector oI the economy is much smaller than it was twenty
years ago. %he main state-owned businesses in the UK are the Royal ail and Network Rail.
State Iunding can also be used to provide merit goods and services and public goods directly to the
population e.g. the government pays private sector Iirms to carry out operations Ior NHS patients to
reduce waiting lists or it pays private businesses to operate prisons and maintain our road network.
Fiscal Policy Intervention
Fiscal policy can be used to alter the level of demand Ior diIIerent products and also the pattern of
demand within the economy.
(a) Indirect taxes can be used to raise the price oI de-merit goods and products with negative
externalities designed to increase the opportunity cost oI consumption and thereby reduce consumer
demand towards a socially optimal level
(b) Subsidies to consumers will lower the price oI merit goods. %hey are designed to boost
consumption and output oI products with positive externalities remember that a subsidy causes an
increase in market supply and leads to a lower equilibrium price
(c) Tax relief: %he government may oIIer Iinancial assistance such as tax credits Ior business
investment in research and development. Or a reduction in corporation tax (a tax on company
proIits) designed to promote new capital investment and extra employment
(d) Changes to taxation and welfare payments can be used to inIluence the overall distribution oI
income and wealth Ior example higher direct tax rates on rich households or an increase in the
value oI welIare beneIits Ior the poor to make the tax and beneIit system more progressive
Intervention designed to close the information gap
OIten market Iailure results Irom consumers suIIering Irom a lack of information about the costs
and beneIits oI the products available in the market place. Government action can have a role in
improving information to help consumers and producers value the true` cost and/or beneIit oI a
good or service. Examples might include:
O Compulsory labelling on cigarette packages with health warnings to reduce smoking
O Improved nutritional inIormation on Ioods to counter the risks oI growing obesity
O Anti speeding television advertising to reduce road accidents and advertising campaigns to
raise awareness oI the risks oI drink-driving
O Advertising health screening programmes / inIormation campaigns on the dangers oI
addiction
%hese programmes are really designed to change the ~perceived costs and benefits oI
consumption Ior the consumer. %hey don`t have any direct eIIect on market prices, but they seek to
inIluence demand and thereIore output and consumption in the long run. OI course it is diIIicult to
identiIy accurately the eIIects oI any single government inIormation campaign, be it the campaign to
raise awareness on the Aids issue or to encourage people to give up smoking. Increasingly adverts
are becoming more hard-hitting in a bid to have an eIIect on consumers.
The effects of government intervention
One important point to bear in mind is that the eIIects oI diIIerent Iorms oI government intervention
in markets are never neutral Iinancial support given by the government to one set oI producers
rather than another will always create winners and losers. %axing one product more than another
will similarly have diIIerent eIIects on diIIerent groups oI consumers.


The law of unintended consequences
Government intervention does not always work in the way in which it was intended or the way in
which economic theory predicts it should. Part oI the Iascination oI studying Economics is that the
law oI unintended consequences oIten comes into play events can aIIect a particular policy, and
consumers and businesses rarely behave precisely in the way in which the government might want!
We will consider this in more detail when we consider government failure.
1udging the effects of intervention - a useful check list
%o help your evaluation oI government intervention it may be helpIul to consider these questions:
Efficiency of a policy: i.e. does a particular intervention lead to a better use oI scarce resources
among competing ends? E.g. does it improve allocative, productive and dynamic eIIiciency? For
example - would introducing indirect taxes on high Iat Ioods be an eIIicient way oI reducing some oI
the external costs linked to the growing problem oI obesity?
Effectiveness of a policy: i.e. which government policy is most likely to meet a speciIic economic
or social objective? For example which policies are likely to be most eIIective in reducing road
congestion? Which policies are more eIIective in preventing Iirms Irom exploiting their monopoly
power and damaging consumer welIare? Evaluation can also consider which policies are likely to
have an impact in the short term when a quick response Irom consumers and producers is desired.
And which policies will be most cost-eIIective in the longer term?
Equity effects of intervention: i.e. is a policy thought oI as Iair or does one group in society gain
more than another? For example it is equitable Ior the government to oIIer educational maintenance
allowances (payments) Ior 16-18 year olds in low income households to stay on in education aIter
GCSEs? Would it be equitable Ior the government to increase the top rate oI income tax to 50 per
cent in a bid to make the distribution oI income more equal?
Sustainability of a policy: i.e. does a policy reduce the ability oI Iuture generations to engage in
economic activity? Inter-generational equity is an important issue in many current policy topics Ior
example decisions on which sources oI energy we rely on in Iuture years.

Balance of Payments of a Country - Introduction
%he balance oI payments oI a country is a systematic record oI all transactions between the residents oI a
country and the rest oI the world carried out in a speciIic period oI time.
India's balance oI payment worsened in the early 1990's but now the situation is under control. In Iact,
India has a good Ioreign exchange reserves mainly due to capital inIlows Irom Ioreign Iinancial
institutions or the stock exchange.
Summary of India's Balance of Payments (Bop)
%able below indicates India's BoP position in between 1990-91 to 2005-06.

Main Components of India's Balance of Payments
1. Trade Balance
%rade balance was in deIicit through out the period shown in the table as imports always exceeded the
exports. Within the imports the POL items constituting a sizeable position continued to increase
throughout. Exports did not achieve the required growth rate. %rade deIicit in 2005-06 stood at $ -51,841
billion US $.
2. Current Account
Current account balance includes visible items (trade balance) and invisibles are in a more encouraging
position. It declined to $ -2,666 million in 2000-01 Irom $-9680 million in 1990-91 and recorded a
surplus in 2003-04 to the extent oI $ 14,083 million. In 2005-06, once again there was a deIicit oI $ 9,186
million. %he main reason Ior the improvement during 2001-05 was the success oI invisible items.
3. Invisible
%he impressive role placed by invisibles in covering trade deIicit is due to sharp rise invisible receipts.
%he main contributing Iactor to rise in invisible receipts is non Iactor receipts and private transIers. As Iar
as non Iactor services receipts are concerned the main development has been the rapid increase in the
exports oI soItware services. As Iar as private transIers are concerned their main constituent is workers
remittance Irom abroad. During this period the private transIer receipts also increased Irom $ 2,069
million in 1990-91 to $ 24,102 million in 2005-06. %he current trend oI outsourcing a number oI jobs by
the developed countries to the developing ones is also helping us to get more jobs and earn additional
Ioreign exchange.
4. Capital Account
Capital account has been positive throughout the period. NRI deposits and Ioreign investment both
portIolio and direct have helped to a great extent. %he main reasons Ior huge increase in capital account is
due to large capital inIlows on account oI Foreign direct investment (FDI); Foreign Institutional Investors
(FIIs) investment on the stock markets and also by way oI Euro equities raised by Indian Iirms. %he Non-
resident deposit also Iorm a part oI capital account.
5. Reserves
Reserves have changed during this period depending on a balance between current and capital account.
An increase in inIlow under capital account has helped us to build up our Ioreign exchange reserve
making the country quiet comIortable on this count. In April 2007 we had $ 203 billion Ioreign exchange
reserves.
%he year 2005-06 registered the highest trade deIicit so Iar running into $ 51,841 million, because oI
rising Oil prices; As a result despite impressive positive earnings oI as much as $ 42,655 million Irom
invisibles, the current account deIicit in this year was $ 9,189 million which is 1.1 oI GDP.
Conclusion
%he balance oI payment situation started improving since 1992-93. %here was a satisIactory balance oI
payment position in that period; the reasons are (i) High earnings Irom invisibles, (ii) Rise in external
commercial borrowings, and (iii) Encouragement to Ioreign direct investment.
%he positive earnings Irom invisibles covered a substantial part oI trade deIicit and current account deIicit
reduced signiIicantly. %he external commercial borrowings was extensively used to Iinance the current
account deIicit. %he net non resident deposits were positive through out the ten year period. %here has
been a growing strength in India's balance oI payment position in the post reIorm period inspite oI
growing trade deIicit and current account deIicit.

The Consumer Price Index (CPI) and PPP
%he CPI is an index that measures the average level oI prices oI goods and services in an economy
relative to a base year. In order to track only what happens to prices, the quantities oI goods purchased is
assumed to remain Iixed Irom year to year. %his is accomplished by determining, with survey methods,
the average quantities oI all goods and services purchased by a typical household during some period oI
time. %he quantities oI all oI these goods together are reIerred to as the average market basket. For
example the survey might Iind that the average household in one month purchases 10 gallons oI gas, 15
cans oI beer, 3.2 gallons oI milk, 2.6 pounds oI butter, etc., etc. %he basket oI goods would also contain
items like health and auto insurance, housing services, utility services and many other items. We can
describe the market basket easily as a collection or set oI quantities (Q
1
, Q
2
, Q
3
, ... Q
n
). Here Q
1
may be
the quantity oI gasoline, Q
2
the quantity oI beer, etc. %he set has "n" diIIerent quantity entries implying
that there are n diIIerent items in the market basket.
%he cost oI the market basket is Iound by surveying the average prices Ior each oI the n products in the
market in question. %his survey would yield a collection or set oI prices (P
1
, P
2
, P
3
, .... P
n
). %he cost oI the
market basket, then, is Iound by summing the product oI the price and quantity Ior each item. %hat is, CB
P
1
Q
1
P
2
Q
2
P
3
Q
3
... P
n
Q
n
(or ).
%he Iirst year in which the index is constructed is called the base year. Suppose 1996 is the base year Ior
the US. Let CB
YY
represent the cost oI the market basket evaluated at the prices that prevail in year YY.
(e.g., CB
00
is the cost oI a market basket evaluated in 2000 prices) %he CPI is derived according to the
Iollowing Iormula,

Where CPI
YY
is the CPI in the year YY. %he term is multiplied by 100 by convention, probably because it
reduces the need to use digits aIter a decimal point. Notice that the CPI in the base year is equal to 100,
i.e., CPI
96
100, because CB
96
/CB
96
1. %his is true Ior all indices - they are by convention set to 100 in
the base year.
%he CPI in a diIIerent year (either earlier or later) represents the ratio oI the cost oI the market basket in
that year relative to the cost oI the same basket in the base year. II in 1997 the cost oI the market basket
rises, then the CPI will rise above 100. II the cost oI the market basket Ialls then the CPI would Iall below
100.
II the CPI rises it does not mean that the prices oI all oI the goods in the market basket have risen. Some
prices may rise more, some less. Some prices may even Iall. %he CPI measures the average price change
oI goods and services in the basket.
%he inIlation rate Ior an economy is the percentage change in the CPI during a year. %hus iI CPI
96
and
CPI
97
are the price indices on January 1
st
, 1996 and 1997 respectively, then the inIlation rate during 1996,
96
, is given by,

!!! Using the C!
%he purchasing power parity relationship can be written using the CPI with some small adjustments. First,
consider the Iollowing ratio oI 1997 consumer price indices between exico and the US,

Given that the base year is 1996, the ratio is written in terms oI the market basket costs on the right-hand
side and then rewritten into another Iorm. %he Iar right-hand side expression now reIlects the purchasing
power parity exchange rates in 1997 divided by the PPP exchange rate in 1996, the base year. In other
words,

In general then iI you want to use the consumer price indices Ior two countries to derive the PPP
exchange rate Ior 1997 you must apply the Iollowing Iormula, derived by rewriting the above,

where represents the PPP exchange rate that prevails in the base year between the two
countries. Note that in order Ior this Iormula to work correctly, the CPIs in both countries must share the
same base year. II they did not, a more complex Iormula would need to be derived.